Also, the degree of real interest rate parity depends on the scope of
uncovered interest parity and relative purchasing power parity. Actually, uncovered interest parity denotes financial investment between money and foreign exchange markets. The relative purchasing power parity means investment in goods and services. Thus the real interest parity condition embraces components of both real and financial integration.
According to Roll (1979), under the efficient market assumption, ex ante deviations from purchasing power parity are unpredictable. (Frankel, 1991), for instance, proposes that breach of ex ante relative purchasing power parity is linked with uncompleted combination of goods markets.
capital is open to shift. For example, an optimal firm fixes its marginal product of capital equal to the consumer cost of capital. The consumer cost of capital is nominal interest rate (without considering taxes and depreciation) attuned to the rate of inflation of its output. Thus the real interest parity is a signal to the equalization of the marginal product of capital. A refinement is drawn in using parity conditions to assess integration. That is, if a parity condition is discarded, then expansions and reductions of differences may happen as a result of either more economic integration or greater union of economic policies, or both.
differentials and the coefficient figures are applied to evalua...
Real Interest Parity
Regression modes are applied to decide the strength of real interest parity (Cumby and Obsfeld, 1984). For instance, interest rate derivatives are returned on inflation
differentials and the coefficient figures are applied to evaluate whether the real interest rate parity condition holds. There is an extensive literature on testing real interest parity according to (Mishkin (1984), Mark (1985), and Cumby and Mishkin (1986)).
Interest Rate Parity (IRP)
Example: U.S. investor has $1 to invest, say for one year. Here, two strategies are to be considered: 1) Investment in U.S. treasury securities at i$, at domestic interest rate, or 2) Invest U.K. treasury securities at i, and hedge FX risk by selling maturity value of s forward one year.
In U.S., the maturity value in one year will be: $1(1 + i$)
In U.K., the investment strategy will be:
1. Sell $1 for s to get $1 S($/) pounds. (assumption that S = S($/)).
2. Invest s at U.K. int. rate ( i) with payoff = $1/S x (1 + i )
3. Sell s forward at F360 ($/) for the maturity value of the UK investment, to get a guaranteed amount of $s.
The IRP condition for the above example will be:
(1 + i$) = (F / S) (1 + i)
Limitation of Interest Rate Parity:
Even though Interest Rate Parity (IRP) hold most of the time, but still IRP does not always hold exactly as it has to be. IRP depends on:
Transaction costs: The borrowing and lending interest rate cannot be assumed to be the same. Interest rates are normally higher for borrowing than for lending. Therefore, higher interest rates for borrowing may do away with or surpass any possible arbitrage profits.
Also, there are transaction costs like commissions,