Define each of the following terms: d. Exchange rate risk; convertible currency; pegged exchange rate
Define each of the following terms:
Interest rate parity: Interest rate parity depicts the relation between the interest rate and the currency exchange rates between domestic and foreign countries. It is the theory which states that the difference between the interest rates preval=iling in the two countries is equal to the difference between the forward exchange rates.
A foreign investment gets affected by two factors. One is the rate of return on investment and other is the variations in the foreign exchange rate. Interest rate parity implies that the investor should yield the same rate of return in home country and foreign country, after adjusting the risk of foreign exchange rate. When the effective rate of return from foreign investment matches with the effective rate of return from a similar domestic investment, then it complies with the interest rate parity.
Purchasing power parity: The concept of purchasing power parity states that the cost of a similar basket of goods in two different countries should be the same, even after considering the effect of foreign exchange rate variations and prices of goods. In simple terms, Purchasing power parity holds when the exchange rate and price of goods adjust so that identical goods cost the same in home and foreign countries. Such relation between exchange rate and price is also referred as “Law of one price”.