Interest Rate Parity Essay

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Aims & Their Importance

Our aim is to find out if there is Interest Rate Parity (IRP) between the USA and China, over an annualised period of 10 years (April 2005-April 2015). We think that this is an important topic as the US are the current global economic superpower, and China is an up and coming power. Also, as there is a lot of trade between the two countries, and we know that china is highly dependant on their exports for GDP growth. A higher Yuan causes exports to slow ( 1% decline for every 10% increase in Yuan), leading to slower economic growth. As economic growth slows, their economy becomes more risky, which adds a risk premium to their interest rates in order to compensate investors for a riskier investment in their economy, as
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In an efficient market, optimal allocation of resources, ideally should keep agents from earning abnormal profits due to the interest rate and exchange rate differential, because these will be priced appropriately to reflect all the available information. The test for market efficiency then should reject any claims for abnormal arbitrage situations that may arise out of forward premium rate deviation beyond the transaction costs from those implied yet by covered interest rate parity (Thornton, 1989).(e.g., Frankel, 1992; Levich, 1979),(Fama, 1970, …show more content…
Interest Rate Parity

Interest Rate Parity (IRP) is a theory that in equilibrium, the forward rate differs from the spot rate by a sufficient amount to offset the interest rate differential between two currencies. This paper examines and does an empirical test of IRP between the United States and emerging China. I conclude that IRP does not hold between the United States and the emerging China economy. The arbitrage exists that investors can borrow from one country and deposit in another country.
(DOES INTEREST RATE PARITY HOLD BETWEEN USA AND THE EMERGING CHINA? Biqing Huang; Xiaowei Liu October 2012 Journal of International Finance Studies;2012, Vol. 12 Issue 4, p85 Academic Journal)
If the Interest Rate Parity (IRP) equilibrium condition does not hold, capital markets may not be efficient. Therefore opportunities for money managers, hedge funds, and other speculators to exploit market misalignments for profit may exist (Adrangi, et al., 2003).
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