The principle of interest rate parity is the expansion of Fisher effect in the international market, that is, the ratio of forward exchange rate to current exchange rate will be equal to the ratio of domestic total interest rate to foreign total interest rate.

Interest rate parity reflects the relationship between exchange rate fluctuation of two currencies and interest rate difference of two currencies.

Capital is profit-seeking, and investors will choose currencies with higher interest rates to invest. If the interest rates of two freely convertible currencies are different, investors will choose the currency according to the level of income.

If the return on local currency investment is high, investors will buy local currency in the spot market for investment, and the local currency will appreciate and the foreign currency will depreciate; In the forward market, investors need to change their local currency into the original currency, so the local currency depreciates and the foreign currency appreciates; On the contrary, the opposite is true.

Conclusion: If the local currency interest rate is high, the discount rate (depreciation range) of the forward exchange rate relative to the spot exchange rate is about equal to the interest rate difference between the two currencies.

Extended data

Exchange rate parity holds that the relationship between spot exchange rate and forward exchange rate is closely related to the interest rates of the two countries. The main starting point of this theory is that the short-term interest rate income gained by investors investing in China should be equal to the short-term investment income gained by converting foreign exchange into foreign exchange at the spot exchange rate and buying back the country's currency at the forward exchange rate.

Once the interest rate difference between the two countries leads to the difference in investment income, investors will carry out arbitrage activities, and the result is to fix the forward exchange rate at a certain equilibrium level. Compared with the spot exchange rate, the forward exchange rate of low-interest countries' currencies will fall, while the forward exchange rate of high-interest countries' currencies will rise. The difference between the forward exchange rate and the spot exchange rate is approximately equal to the interest rate difference between the two countries.

Rate parity can be divided into a set of interest rate parity and a set of interest rate parity.

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