Table of Contents
What is IRP theory and PPP theory?
The IRP theory is based on the notion that high interest rates are driven by high inflation rates (see the PPP above), so a comparatively high interest rate would signal a comparatively high level of inflation.
What is IRP theory?
What Is Interest Rate Parity (IRP)? Interest rate parity (IRP) is a theory according to which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.
What is the difference between absolute PPP and relative PPP?
Absolute PPP states that the exchange rate between two currencies equals the ratio of their price levels. Relative PPP states that the percentage change in the exchange rate between two currencies over a given period equals the difference between the inflation rates of those two currencies.
What is the difference between covered interest rate parity and uncovered?
Covered interest parity involves using forward contracts to cover the exchange rate. Meanwhile, uncovered interest rate parity involves forecasting rates and not covering exposure to foreign exchange risk—that is, there are no forward rate contracts, and it uses only the expected spot rate.
What is the formula for IRP theory?
What is the Interest Rate Parity (IRP) Equation? For all forms of the equation: St(a/b) = The Spot Rate (In Currency A Per Currency B) ST(a/b) = Expected Spot Rate at time T (In Currency A Per Currency B)
How do you calculate IRP?
There are different interest rate parity equations for covered and uncovered IRP….Interest rate parity formula
- ST(a/b) = The Spot Rate.
- St(a/b) = Expected Spot Rate at time T.
- Ft(a/b) = The Forward Rate.
- T = Time to Expiration Date.
- ia = Interest Rate of Country A.
- ib = Interest Rate of Country B.
Does relative PPP imply absolute PPP?
Unlike absolute PPP, relative PPP predicts a relationship between changes in prices and changes in exchange rates, rather than a relationship between their levels. But the converse need not be true: relative PPP does not necessarily imply absolute PPP (if relative PPP holds, absolute PPP can hold or fail).
What is the difference between PPP and exchange rates?
Market Exchange Rates (MER) balance the demand and supply for international currencies, while Purchasing Power Parity (PPP) exchange rates capture the differences between the cost of a given bundle of goods and services in different countries.
What are the different types of purchasing power?
There are two forms of the Purchasing Power Parity: absolute and relative. where is the FX rate, is the price level in the home country, and is the price level in the foreign country.
What will happen if interest rate parity IRP does not hold?
If the interest rate parity relationship does not hold true, then you could make a riskless profit. The situation where IRP does not hold would allow for the use of an arbitrage. To do this, you would borrow money, exchange it at the spot rate, invest at the foreign interest rate and lock in the forward contract.