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Business LibreTexts

5: Interest Rate Parity

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    Interest rate parity is one of the most important theories in international finance because it is probably the best way to explain how exchange rate values are determined and why they fluctuate as they do. Most of the international currency exchanges occur for investment purposes, and therefore understanding the prime motivations for international investment is critical.

    The chapter applies the rate of return formula developed in Chapter 4 "Foreign Exchange Markets and Rates of Return" and shows how changes in the determinants of the rate of return on assets affect investor behavior on the foreign exchange market, which in turn affects the value of the exchange rate. The model is described in two different ways: first, using simple supply and demand curves; and second, using a rate of return diagram that will be used later with the development of a more elaborate macro model of the economy.