Approximating Interest Rate Parity Formula

E

Interest rate parity will hold when there are no covered interest arbitrage opportunities.

Interest rate parity is an economic theory that suggests that the difference in interest rates between two countries should be equal to the expected change in the exchange rate between their currencies. This theory is based on the assumption that investors are rational and seek to maximize their returns.

The formula for approximating interest rate parity is as follows:

rh - rf = (f1 - e0) / e0

Where:

• rh represents the home country interest rate
• rf represents the foreign country interest rate
• f1 represents the expected future exchange rate
• e0 represents the current exchange rate

Let's break down the formula to understand its components:

1. rh - rf: This term represents the interest rate differential between the home country and the foreign country. It calculates the difference in interest rates between the two countries.

2. (f1 - e0): This term represents the expected change in the exchange rate between the home country and the foreign country. It calculates the difference between the expected future exchange rate (f1) and the current exchange rate (e0).

3. e0: This term represents the current exchange rate between the home country and the foreign country. It is the rate at which one currency can be exchanged for another at the present time.

By equating the interest rate differential (rh - rf) to the expected change in the exchange rate ((f1 - e0) / e0), the interest rate parity formula expresses the idea that the returns from investing in different currencies should be equalized when accounting for the expected exchange rate movements.

Therefore, the correct answer to the question is option E: rh - rf = f1 - e0/e0.