If there was one tool that could help any business dealing with international trade, it would be the Interest Rate Parity, however, words that come after the first three are usually something like theory, concept, or model, because that exactly what it is. The basic idea of this “theory” is to somewhat combine exchange rates and interest rates into a formula, which would be very beneficial to importers and exporters around the world when dealing with forward or spot rates. All of this is to regulate, or prevent, investors from practicing arbitrage. This model is set in place so that if companies were to invest in a foreign market, their return wouldn’t be any higher than the interest rate return they would get by investing domestically.

When the theory works, it is called covered interest rate parity. The goal of this theory is zero, which is hopefully the difference between investing in foreign markets compared to domestic markets. The formula used during the uncovered method, when IRP works is when the home interest rate minus the foreign interest rate is equal to the forward rate minus the spot rate, divided by the spot rate. If that formula results in two different numbers then the IRP does not stand true.

When the IRP theory doesn’t work, then investors have an opportunity to practice arbitrage. Investors will take advantage of this to make a higher return, which also results in an uneven flow of money from one country’s market to another. Money will flow from a domestic market to a foreign market if one plus the domestic interest rate is less than one plus the foreign interest rate, multiplied by the forward rate, all divided by the spot rate. In the opposite case, money will flow from foreign markets to domestic markets if the last example was greater than. Like I stated earlier, the interest rate parity is just a theory some people believe in it, some don’t, sometimes it works, and other times, the formula doesn’t hold strong. It is all just set up to keep a balance and even flow of currency from market to market.

Sources:

“Interest rate parity" Encyclopædia Britannica. 2009. Encyclopædia Britannica Online. 05 Nov. 2009. http://www.britannica.com/bps/additionalcontent/18/35618441/INTEREST-RATE-PARITY-AND-CURRENCY-OPTION-PRICE

"Interest rate parity" Investopedia. Web. 3 Nov. 2009.

http://www.investopedia.com/terms/i/interestrateparity.asp

Go, Pauline. "Purchasing Power Parity And Interest Rate Parity." Ezinearticles. Web. 3 Nov. 2009. <http://ezinearticles.com/?Purchasing-Power-Parity-And-Interest-Rate-Parity&id=954958>.