Parity conditions in International Finance and Currency Forecasting Essay

Parity conditions in International Finance and Currency Forecasting - Essay Example These global investors are encouraged by the differences that exist among countries in the return rates on assets that are comparable. The theory also proposes that the exchange rate value on the foreign exchange market is affected by the transactions that are undertaken on the financial account of a country (Mukherjee, 2002). Madura, (2014) says that, the interest rate parity is an equilibrium. Why is this so? The author notes that, when the exchange and the interest rates are made to change and adjust to the forces in the market in a way that the interest arbitrage is not achievable, then an equilibrium results. The equilibrium is termed as the interest parity. Hence, when an equilibrium exists, the forward rate varies from the spot rate by an adequate extent. The variation is to such an extent that it counterbalances the interest rate differential among the countries’ currencies. For example, if an investor from the US obtains a greater rate of interest from his or her foreign investment; and he or she has to pay extra per entity of the country’s currency than what he or she obtains per entity when the country’s currency is sold forward, then there is a counterbalancing influence. Hence, if the investor has invested in the UK and the UK pound has an interest rate of 4%, while the equivalent in the US has an interest rate of 1%. Then, the two currencies’ interest rate differential is 3% (4 – 3). It implies that the interest rate differential is the profit the investors presume. However, the exchange rate must remain constant if the profit is to hold (Grath, 2011). In the example, the â€Å"pay extra per entity of the country’s currency†¦Ã¢â‚¬  is what is termed as the spot rate. While, â€Å"what he or she obtains per entity when the country’s currency is sold forward,† is known as the forward rate. Normally, when the spot rate is more than the forward rate, then a discount is in the