Certified Management Accountant Practice Exam

Interest Rate Parity primarily deals with what concept?

1. Currency exchange rates only

2. Forward rates and interest rate variables

3. Inflation rates and their effects

4. Loan interest rates in domestic markets

The correct answer is: Forward rates and interest rate variables

Interest Rate Parity (IRP) is a fundamental principle in international finance that establishes a relationship between the forward exchange rates and the interest rates of two countries. The core idea of IRP is that the difference in interest rates between two countries is equal to the expected change in exchange rates between their currencies. This means that if one country has a higher interest rate compared to another, the currency with the higher interest rate is expected to depreciate in order to maintain parity. When investors can earn different returns from investments in different currencies, they will adjust their currency positions through the foreign exchange markets. If the IRP condition holds true, it minimizes the opportunity for arbitrage, thus ensuring that the returns on investments, once adjusted for exchange rate fluctuations, are equivalent across different currencies. This makes the connection of IRP to forward rates and interest rate variables crucial, as it directly informs how investors and businesses manage the risks and potential rewards associated with currency fluctuations and international capital flows. The other options do not encompass the full effect of interest rate parity in this context, focusing instead on narrower aspects of finance that do not fully encapsulate the essence of interest rate parity.