Interest Rate Parity: Expression 2

An introduction to Interest Rate Parity

Category:

Education

Tags:

• finance
• international finance
• parity conditions
• interest rate parity

[jayto1789]

i don't know dude, you haven't convinced me yet. i mean e.g. this francois guy makes 10% if he stays in europe, and 9.76% if he goes to the US. on the other hand the american guy makes 5% if he stays in the US and 5.24% if he invests in Europe. To me that means, both invest in Europe because that's where they get the highest return.

In the end you write I(D) = I(F) - (F-E)/E, which is not true in my opinion because 5% is not equal to 5.24% in the example. What did I mess up?

[csbhatnagar]

@jayto1789 In absolute return terms, yes, you are right. But keep in mind FOREX gains/losses. If Francois invests abroad (U.S), at some point in time, he has to repatriate the return home. If at that time, the dollar has appreciated he gets more Euros. So, his return in Euro terms improves. In the U.S, he gets 5% and gains 4.76% (FOREX gain) when the money is sent back to Europe. But in Europe itself, he can get 10%. So, there is no need for him to take the trouble of going to U.S.

[csbhatnagar]

@jayto1789 Al can earn 5% in the U.S. He can be tempted by the 10% in Europe but when he brings the Euros back home, he loses (lesser $ for his Euros) because the Euro has depreciated. So, from his absolute gain of 10%, the FOREX loss is subtracted, leaving him with just 5.24%, which may not be a good enough reason to take all the trouble to invest in Europe because he can get a comparable return of 5% at home. The extra .24% is going to be absorbed by transaction costs anyway.

[nehasaini1111]

thanks a ton.........

[sendtoharvey]

these are so much easier to understand than my textbook

[bumper3000]

TWO THUMBS UP! Thank you!

[GodblessHunt]

Excellent! Thank you so much!