The term interest parity expresses that the returns for an investment in domestic or foreign currency are the same. The statement is made on the condition that exchange rate fluctuations of the currencies on which the return comparison is based are taken into account.

This means that two returns, which have numerically different sizes, adjusted for the differences in the exchange rate, are effectively the same.

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## Interest parity theory

Assuming the parity of returns from different currency areas, there are two basic statements. These theoretical approaches can be traced back to John Keynes, one of the most important economists of the 20th century.

On the one hand, the interest parity theory justifies the behavior of investors when investing their capital. The investor always invests where he expects the highest returns. From this, the second thought is derived that exchange rate movements can be traced back to precisely this endeavor on the part of investors.

Investors' interest in returns is the cause of changes in exchange rates.

## Covered and uncovered interest parity

When looking for high returns, the investor basically has two options with a view to the factor of exchange rates and their effect on returns.

**Uncovered interest parity** - With uncovered interest parity, the investor leaves the currency exchange rate risk position open. He deliberately speculates on a return effect from the exchange rate.

Such return effects are also known as currency arbitrage. Since the investor bears the full risk from the currency exchange of his capital investment, he also has to accept yield losses. They occur when exchange rates change in favor of its local currency.

The nominal return on its foreign investment effectively deteriorates as the foreign currency depreciates.

**Covered interest parity** - With covered interest parity, the investor excludes this risk. His capital investment is hedged against changes in the exchange rate of the currencies by means of a forward transaction. The technical term for such hedging transactions is swaps.

Die Grundfunktion eines solchen Termingeschäfts besteht darin, den Umtauschkurs der Währungen für die Zukunft, bereits bei Abschluss der Kapitalanlage, festzulegen. Damit ist die effektive Rendite zum Zeitpunkt der Kapitalanlage gleich der effektiven Rendite, die der Anleger ein Jahr später bei Umtausch der currency erhält.

The actual exchange rate on the stock exchanges that applies to the market at the time the currency is exchanged has no influence on its currency exchange - the exchange rate risk is thus excluded.

## Requirements for interest parity

In order for interest parity to work in practice, there are some basic requirements in the markets. The three most important ones include a very high capital mobility, the associated complete possibility of converting securities, as well as a corresponding currency market efficiency.

The mobility of capital as well as the unrestricted conversion of securities are basic prerequisites for the market reactions to take place promptly and with undistorted content.

The currency market efficiency is the basis for real exchange rates. Only when all the relevant information is available and can be used by all market participants do the exchange rates also reflect the necessary market mechanisms for effective interest parity.

## Condition for an interest parity

Interest rates and exchange rates between domestic and foreign investments balance each other out in market behavior to achieve equality of return. This means that a devaluation of a currency in one country against another currency leads to an increase in the nominal interest rate for investments in this country and vice versa.

The investor is on an equal footing with a capital investment in Germany or abroad with regard to his effective return.

## Summary

- Interest parity means the same effective return on capital investments at home or abroad
- there is a covered and uncovered interest parity
- Interest parity requires a perfect and absolutely liquid market to function
- Investors always invest in the highest return, changes in exchange rates are a reaction to this endeavor