Jim Whitney
The interest parity condition (IPC)
    The interest parity condition (IPC) is based on international transactions involving financial assets. The logic is that similar assets everywhere should ultimately yield the same expected return to investors. The return on domestic assets depends only on the domestic interest rate (i). But the return on foreign assets depends on the foreign interest rate (i*) and on any expected change in exchange rates during the time you invest abroad. Foreign currency appreciation is an extra gain, and foreign currency depreciation is an offsetting loss.
    The key result: For returns to be equalized across countries, expected exchange rate changes should exactly offset any interest-rate differentials:
        expected %DE = i* - i
So when we see a low interest rate at home compared to abroad, savers must expect the domestic currency to appreciate, and a high interest rate at home compared to abroad must mean that savers expect the domestic currency to depreciate.

Comparing foreign and domestic earnings:
   Save at home: 1 unit grows to:                            (1+i)
   Save abroad: Step1: Convert to foreign exchange:      --> Es units
                Step2: Earn savings abroad:              --> (1+i*)·Es
                Step3: Convert back to domestic currency:--> (1+i*)·Es/Ef
   The interest parity condition is met when these returns are the same:
        IPC: (1+i) = (1+i*)·Es/Ef
 

  General formula Hypothetical example Real-world example
4/9/99-7/9/99 (3mos. instead of 1yr)
  Given:
   i
   i*
   Es (spot ER)
   Ef (forward ER)		 Given:
   i US = 6.6% (.066)
   i GER = 4.0% (.04)
   Es = 2.05 Mk/$
   Ef = 2.0 Mk/$		 Given:
   i US = 4.364% (.04364)
   i GER = 2.660% (.0266)
   Es 4/9/99 = 1.8118 Mk/$
   Ef 7/9/99 = 1.8015
   i US for 3 mos:  .04364/4 
      = .01091
   i GER for 3 mos: .0266/4
      = .00665
Option 1: Save at home: End up with: 
     (1+i)    (1+i) = $1.066    (1+i) = $1.01091
Option 2: Save abroad: 
Step1:     Es     2.05 Mks    1.8118 Mks
Step2:     (1+i*)·Es    (1.04)·2.05 = 2.132 Mks    (1.00665)·1.8118 = 1.8238 Mks
Step3:     (1+i*)·Es/Ef    (2.132 Mks) / (2.0 Mk/$) = $1.066    (1.8238 Mks) / (1.8015 Mk/$) = $1.0123
Result:   Returns are equal Slightly higher interest on German savings: 
   .0123·4 = .0492 = 4.92% return 
   compared to 4.364% in the U.S.
    To do: Compare the U.S. interest rate to the return you would earn on savings in Japan for 3 months: Given: i Japan: 0.104% (0.00104 per year, .00026 for 3months), Es 4/9/99: 120.88 Yn/$, Ef 7/9/99: 119.42 Yn/$.