What is the parity of interest rates?

Once you start managing finances in any part of the world, it is important to know how the economic fluctuations are On a daily basis, these cause a change in the valuation of any existing currency to be generated.

Based on this, the markets also show changes, since they are always associated with a price of currency changes. That is why the parity of interest rates is found , generating appropriate formulas to perform these calculations between two countries.

All this can be generated from a covered rate and a discovered one , finding here the general operation of this system so effective.

What is the parity of interest rates?

Interest rate parity is considered an economic theory in charge of establishing a general formula. It stipulates that the interest rate in a country is equal to the expected exchange rate between the current change that is governed at the moment, by the interest rate in another country.

All of this means that if there is a favorable difference in interest rates , it will also exist in exchange rates. Then, the future exchange rate will be higher than the current one.

That is why in countries with higher interest rates, their currency has to depreciate in the future , resulting in the complete description of the formula. In relation to this, it can be said that the difference between the interest rates will have parity between the exchange rates. Therefore, its formula will be given by adding 1 + the domestic interest rate , which will be divided by 1 + the foreign interest rate .

With this, according to the figures used, it will be possible to establish how one currency is going to depreciate with respect to the other. Thus, arbitrage in the currency market will be avoided, giving complete control of currency management between different nations in all its aspects.

All this makes it possible to calculate an interest rate and inflation constantly, knowing the fluctuations found in all financial movements.

Operation of the hedged interest rate parity

This type of rate is used to avoid the economic risk of the exchange rate of a country, avoiding those economies that after economic deficits may affect the country and its investors.

In this way, the investor will not have the problem that the money invested is lost when said currency is devalued. All this is well understood by different financial entities , needing to calculate the periodic bank interest rate for further data collection.

How the uncovered interest rate parity works

The uncovered interest rate parity, or without coverage, works in such a way that investors have the same perception of profits with respect to the country’s growth, but it is the most vulnerable to any economic downturn, therefore it is more risky and substantial, before this it is the least protected against any type of sudden change.

All this can be predicted by studying currency data for a whole year, determining what the changes will be. Thus, the possibility of finding an effective equalization of the interest rate parity is given more clearly .

From an interest rate and discount rate at a general level, an analysis of what has been generated can also be given. With the use of platforms like FXStreet , some graphs and analysis can be obtained in real time. 

All this will make the process easier to carry out, creating a constant review of the changes generated. With this, it is possible that the predictions are given correctly, taking into account that some changes cannot be predicted.


by Abdullah Sam
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