Exchange rate parity
Exchange rate parity holds that the difference between interest rates of two countries is equal to the difference between forward exchange rate and spot exchange rate.
Interest rate parity holds that as long as there is a gap in interest rates between the two countries in the same period, investors can earn the difference through arbitrage or arbitrage, and the exchange rates of the two currencies will fluctuate because of this arbitrage until the arbitrage space disappears. According to exchange rate parity, the interest rate gap between the two countries will affect the monetary level and the movement of funds, and then affect the difference between the forward exchange rate and the spot exchange rate. When the two are in equilibrium, the premium or premium of the forward exchange rate should be equal to the difference between the interest rates of the two countries, otherwise there will be risk-free arbitrage to restore the equilibrium.
This theory was put forward by Keynes and Eindziger.
The challenge of interest rate parity
The ability of interest rate parity to explain emerging market crisis. The financial crisis in emerging markets involves a large amount of international capital entering or leaving a country's financial market, which directly verifies the explanatory power of interest rate parity. Judging from the nature of the emerging market crisis, the trigger of the currency crisis is the speculation of short-term international hot money, and speculators decide the investment of funds according to the prices or yields of financial assets such as stocks, bonds and currencies. Because there is a negative correlation between asset prices and interest rates, and the currency exchange involved in investment income will also be affected by the exchange rate level, which is reflected in the financial market. The basis of investment decision-making is actually the linkage relationship among interest rate, exchange rate and interest rate parity.