Charta is on Google Play: practise on the go. Get the app
Charta

Explain the international parity conditions, namely interest rate parity in its covered and uncovered forms, the international Fisher effect, purchasing power parity and forward rate parity

CFA® Level II · Economics · Currency Exchange Rates: Understanding Equilibrium Value · L2.EC.1.e

The idea

Covered interest parity is an arbitrage condition: the forward premium offsets the interest differential, so a hedged foreign deposit earns the domestic rate. Uncovered interest parity says the expected spot change equals the interest differential, so the high-yield currency should weaken by that amount. Nothing enforces uncovered parity, and it often fails in the short run. Forward rate parity says the forward rate is an unbiased forecast of the future spot. Relative purchasing power parity says exchange rates move by the inflation differential. The international Fisher effect says nominal rate differentials equal expected inflation differentials, so real rates are equal. Only covered parity is enforced by arbitrage, so it holds closely, though small deviations (the cross-currency basis) have persisted since 2008.

In the app: 3 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.

Take the free diagnostic →

More in Currency Exchange Rates: Understanding Equilibrium Value