LEVEL II
International parity conditions are a set of relationships that exist between different financial variables in international finance. These conditions help explain the relative prices of financial assets in different countries and are crucial for understanding the global financial market. The five key conditions are:
- Covered Interest Rate Parity (CIRP): States that the difference between two countries’ interest rates should equal the forward exchange rate premium or discount, adjusting for the expected difference in exchange rates between the present and the time when the money is returned.
- Uncovered Interest Rate Parity (UIRP): States that the difference between two countries’ interest rates is equal to the expected change in the exchange rate. Unlike CIRP, UIRP does not take into account the use of forward contracts to hedge against exchange rate risk.
- Forward Rate Parity (FRP): States that the forward exchange rate should equal the spot exchange rate adjusted for the difference in interest rates between two countries.
- Purchasing Power Parity (PPP): States that the exchange rate between two countries should equal the ratio of the domestic price level to the foreign price level.
- International Fisher Effect (IFE): States that the nominal interest rate differential between two countries is equal to the expected rate of depreciation of one currency relative to the other.
These conditions are interrelated and provide a comprehensive understanding of the global financial market, particularly with regards to international trade and investment.
