Which one of the following is characterized in the interest rate parity?

Correct option is D

​Interest Rate Parity (IRP) is a fundamental principle in international finance that explains the relationship between interest rates and exchange rates. It states that:

where:

• $F$ = Forward exchange rate

• $S$ = Spot exchange rate

• idi_di_d = Domestic interest rate

• ifi_fi_$f$= Foreign interest rate

According to IRP, the difference in interest rates between two countries determines the forward exchange rate to prevent arbitrage opportunities.

• Option (4) is correct because Interest Rate Parity characterizes the relationship between interest rates and exchange rates of two countries.

• IRP ensures that investors cannot make risk-free profits through currency arbitrage.

Information Booster:

1. Interest Rate Parity (IRP) is classified into two types:

   1. Covered Interest Rate Parity (CIRP):Forward rates adjust to prevent arbitrage.

   2. Uncovered Interest Rate Parity (UIRP):Expected future spot rates adjust based on interest rate differentials.

2. Implications of IRP:

   1. Ensures that foreign exchange markets remain efficient.

   2. Affects international investment and hedging decisions.

   3. Explains why currencies of countries with higher interest rates tend to depreciate over time.