The interest parity condition (IPC)

    Basic theory: The interest parity condition (IPC) is based on international transactions involving financial assets. The logic is that, in a world of perfectly mobile financial assets, similarly risky assets everywhere should ultimately yield the same expected return to investors. When comparing returns across countries, both interest rates and expected exchange-rate changes play a role.
    The interest parity condition states the relationship between interest rates and expected exchange-rate changes which ensures equality of expected returns across countries:
        Expected %DE = ifor - idom.
Three situations can arise:

	Situation	Example
(1)	The exchange rate is expected to remain perfectly stable: idom = ifor.	Domestic and foreign interest rates both equal 2%.
(2)	The foreign interest rate exceeds the domestic interest rate, and the domestic currency is expected to appreciate by the difference. Expected %DE = ifor - idom > 0. There is a "forward premium" on domestic currency.	If the foreign interest rate is 3% and the domestic interest rate is 2%, then savers must expect the domestic currency to appreciate at an annual rate of 1%.
(3)	The foreign interest rate is below the domestic interest rate, and the domestic currency is expected to depreciate by the difference. Expected %DE = ifor - idom < 0. There is a "forward discount" on domestic currency.	If the foreign interest rate is 3% and the domestic interest rate is 4%, then savers must expect the domestic currency to depreciate at an annual rate of 1%.

The bottom-line implication of the IPC: Whenever we see a low interest rate at home compared to abroad, savers must expect that the domestic currency is going to appreciate, and whenever we see a high interest rate at home compared to abroad, savers must expect that the domestic currency is going to depreciate. And the amount of expected currency adjustment matches the interest-rate differential.

Applying the interest parity condition: Consider the following information about the annual percentage rates of inctest on domestic and foreign interest on 3-month government bonds as of mid-October 1997:

Use the interest parity condition to estimate the expected annual rate of dollar appreciation (%DE>0) or depreciation (%DE<0) as of mid-October 1997:

Expected %DE versus...	British pound	French franc	German mark	Japanese yen
Expected %DE versus...		-2.18%