Final answer:
Interest rate parity is a finance theory that suggests the difference in interest rates between two countries is equal to the change expected in their exchange rates, eliminating arbitrage. It is closely related to forward rates, which should reflect interest rate differentials to prevent arbitrage opportunities. This concept ties into purchasing power parity, indicating that over time, exchange rates align with the currency's buying power.
Step-by-step explanation:
Interest rate parity is a financial theory which postulates that the difference between interest rates offered in two different countries is equal to the rate at which the forward exchange rate of their currencies is expected to move to offset any potential gain or loss from arbitrage. In other words, if one country's interest rates are higher, its currency should depreciate in the future, relative to a country with lower interest rates, in the forward exchange rates market. This plays a role in hedging, investments, and can influence the flow of capital between nations.
The relationship between interest rate parity and forward rates is fundamental. The theory suggests that the forward rate should incorporate the interest rate differential between two countries; otherwise, an opportunity for arbitrage would exist. If the current exchange rate and the respective countries' interest rates do not satisfy interest rate parity, traders could exploit this for profit through a strategy called 'covered interest arbitrage', borrowing in the currency with the lower interest rate and investing in the currency with the higher rate.
Understanding interest rate parity is essential, particularly in purchasing power parity scenarios. Purchasing power parity indicates that in the long run, exchange rates should even out such that the purchasing power across different countries is equivalent when it comes to internationally traded goods. If businesses find that goods are cheaper in one country, they will buy there and sell where prices are higher, which will influence the exchange rates and eventually restore purchasing power parity.