**Interest parity definition**

Interest rate parity (IRP) is a theory that helps to explain the relationship between exchange rates and interest rates. It states that the difference in interest rates between two countries should be equal to the difference in the expected appreciation or depreciation of the currencies of those countries. In other words, if the interest rate in one country is higher than the interest rate in another country, then the currency of the country with the higher interest rate should appreciate relative to the currency of the country with the lower interest rate.

The basic idea behind interest rate parity is that investors will be attracted to countries with higher interest rates because they can earn a higher return on their investments. This leads to an inflow of capital into the country with the higher interest rate, which increases demand for the currency and causes it to appreciate. Conversely, if a country has a lower interest rate, investors will be less attracted to it and there will be an outflow of capital, which decreases demand for the currency and causes it to depreciate.

There are several factors that can affect the relationship between exchange rates and interest rates. For example, if a country has a high level of inflation, it may need to set a higher interest rate in order to attract investors and keep its currency stable. On the other hand, if a country has low inflation and a strong economy, it may be able to set a lower interest rate without affecting the value of its currency.

Overall, interest rate parity is an important theory that helps to explain the relationship between exchange rates and interest rates and the factors that can influence this relationship. It is an important concept for investors, businesses, and policymakers to understand when making decisions about currency exchange and investme

** Versions of interest rate parity (IRP) theory**.

- One version is known as the “uncovered interest rate parity” or “absolute interest rate parity,” which states that the expected change in the exchange rate between two currencies is equal to the difference in their interest rates. This means that if the interest rate in one country is higher than the interest rate in another country, the currency of the country with the higher interest rate should appreciate relative to the currency of the country with the lower interest rate.
- Another version of IRP theory is known as “covered interest rate parity,” which considers the impact of currency risk on international investment decisions. This theory states that the expected change in the exchange rate between two currencies should be equal to the difference in their interest rates, minus the cost of hedging against currency risk. This means that if an investor wants to invest in a country with a higher interest rate but is concerned about the risk of exchange rate fluctuations, they may need to purchase a currency hedge in order to protect their investment.

Both versions of interest rate parity theory assume that capital is perfectly mobile and that there are no transaction costs or barriers to international investment. However, in reality, there are many factors that can affect the relationship between exchange rates and interest rates, including inflation, government policies, and market conditions.

Despite these limitations, IRP theory is an important concept in international finance and helps to explain the relationship between exchange rates and interest rates and the factors that can influence this relationship. It is used by investors, businesses, and policymakers when making decisions about currency exchange and international investments.

In addition to the uncovered interest rate parity (UIRP) and covered interest rate parity (CIRP) theories, there is another version of interest rate parity (IRP) known as “fisher effect.” This theory, proposed by economist Irving Fisher, states that the nominal interest rate in a country is equal to the real interest rate plus the expected inflation rate. In other words, the nominal interest rate reflects the opportunity cost of lending money and the expected depreciation of the currency due to inflation.

The fisher effect can be used to explain how changes in interest rates can affect exchange rates. If a country raises its interest rate, it may attract more international investors and cause an inflow of capital, which can lead to an appreciation of the currency. On the other hand, if a country lowers its interest rate, it may become less attractive to international investors and lead to an outflow of capital, which can result in a depreciation of the currency.

It’s important to note that the fisher effect assumes that there are no transaction costs or barriers to international investment. However, in reality, there are many factors that can affect the relationship between exchange rates and interest rates, including inflation, government policies, and market conditions.

Overall, interest rate parity theory is an important concept in international finance that helps to explain the relationship between exchange rates and interest rates and the factors that can influence this relationship. It is used by investors, businesses, and policymakers when making decisions about currency exchange and international investments.

To conclude, interest rate parity (IRP) is a theory that helps to explain the relationship between exchange rates and interest rates. There are several different versions of IRP theory, including uncovered interest rate parity (UIRP), covered interest rate parity (CIRP), and the fisher effect. These theories all assume that capital is perfectly mobile and that there are no transaction costs or barriers to international investment, but in reality, there are many factors that can affect the relationship between exchange rates and interest rates.

**Limitations of interest rate parity theory**

**1) Assumes Perfect Market**

The interest rate parity assumes a perfect market. A perfect market is a market where all information is readily available to the market participants.

Perfect markets are also characterized by a high number of transactions, homogenous products, no barriers to entry, and no transaction costs. The perfect market is a theoretical market and does not exist in the real world.

When interest rate parity suggests an offset between interest rates and spot and forward exchange rates of currencies of two countries, it assumes a perfect market exists.

This means that the interest rate parity theory assumes that the only factor that affects the difference between forward and spot exchange rates is the interest rates of the two countries.

However, in the real world, due to market imperfectness, there may be more than these reasons that dictate the differences between the two rates.

**2) Assumes Capital Mobility**

Another limitation of the interest rate parity theory is that it assumes capital is freely mobile. It means that the theory assumes that entities can easily move the capital from one country to another.

This also relates to perfect markets as it also assumes that there are no transaction costs in moving the capital from one country to another.

In real world, capital is not freely mobile. To transfer capital from one country to another, entities must bear different type of costs.

These costs can be in different forms such as taxes and tariffs on the transfer of capital. Some countries may even limit the amount of capital that can be transferred from or to it.

Furthermore, there are different rules and regulations both national and international that must be considered when moving the capital from one country to another.

**3) Assumes Perfect Asset Interchangeability**

The interest rate parity theory also assumes that assets are perfectly interchangeable in two countries.

It assumes that entities looking to borrow in one country and invest it in another country can find instruments of the same class and risk in both countries.

This is not true in the real-world as different countries do not have the same class of assets with similar risks.

**4) Assumes No-Arbitrage**

As mentioned, the interest rate parity assumes arbitrage does not exist. This is mainly due to the other assumptions that the theory makes. In the real world, entities exploit market conditions in many ways to achieve arbitrage.

No-arbitrage only exists inefficient markets, however, as demonstrated above, efficient markets do not exist due to different types of market deficiencies.

**Thanks for reading this article . Have a fruitful day ,won’t you!!!**