Interest Rate Parity Model

The Model of Interest Rate Parity states that in the event that two different currencies have different interest rates, then that difference will be reflected in the premium or discount to the price in the future, in order to avoid arbitration without risks.

For example, if interest rates in the U.S. are 3% and the interest rates of Japan are 1%, then the U.S. dollar (USD) should depreciate against the Japanese yen (JPY) by 2% to avoid what is known as risk arbitrage. This price or future exchange rate is expressed in the price at future date (forward) indicated on the current date.
In this example, it is said that the price or forward exchange rate for the U.S. dollar is at a discount because this currency buy less yens in the forward price that in the spot price. Therefore, it is said that the Japanese yen is at a premium.

In recent years, the parity of interest rates has not produced the best results. This is because usually the currencies with higher interest rates increase as a result of the decisions of central banks, which try to reduce the rate of an economy that is excessively revolutionized by the rise in interest rates. This type of actions taken by central banks have no relation with risk arbitrage.

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