This document discusses uncovered interest rate parity (UIRP) and covered interest rate parity (CIRP), which relate interest rates between countries to exchange rates. UIRP refers to parity when exposed to exchange rate risk, while CIRP uses forward contracts to eliminate exchange rate risk. The document provides an example where UK interest rates are 2% and Japanese rates are 1%, requiring the pound to depreciate 1% against the yen to avoid arbitrage opportunities. It also discusses purchasing power parity (PPP), which estimates exchange rates needed for currencies to have equal purchasing power based on market baskets of goods. PPP helps minimize misleading international comparisons that can arise from using market exchange rates alone.

1. Relation of IRP
& PPP
SUMIT KUMAR DAS
Roll- 95/MBA/130020
MBA – Calcutta University Alipur Campus

2. I R P & P P P P a g e | 1
It’s no-arbitrage condition representing an equilibrium state under which investors
will be different to interest rates available on deposits in two countries. The fact
that this condition doesn’t always hold allows for potential opportunities to earn
risk less profits from covered interest arbitrage.
Two assumptions central to interest parity are capital mobility and perfect
sustainability of domestic and foreign assets. Given foreign exchange market
equilibrium the interest rate parity condition implies that the unexpected return on
domestic assets will be equal to the exchange rate adjusted expected on foreign
currency assets. Inventors that can’t earn arbitrage profits by borrowing in a
country with a higher interest rate, due to gain or losses from exchanging back to
their domestic currency at maturity.
Interest rate parity takes 2 distinctive forms:-
 Uncovered Interest Rate Parity (UIRP): it refers to the parity condition in
which exposure to foreign exchange risk(unanticipated change in exchange
rates) is unhabituated
 Covered Interest Rate Parity (CIRP): it refers to the condition in which a
forward contract has been used to cover (eliminate exposure to) exchange
rate risk.
In Simple with examples:-
This theory assumes that if two countries have different interest rates, this
difference will lead to a discount or a premium for the exchange rate in order to
avoid arbitrage opportunities. IRP has to do with the idea that money should (after
adjusting risk) earn an equal rate of return.
A simple example would be a situation, where interest rates in the UK are say 2%;
while interest rates in Japan are say 1%. The sterling (British money) will need to
depreciate 1% against the Japanese yen, so that the arbitrage opportunities can be
avoided. The future exchange rate of GBP/JPY is reflected in the forward exchange
rate known today.

3. I R P & P P P P a g e | 2
Suppose an investor can earn 6% interest with a dollar deposit in the United States
bank; or can earn 4% interest with a British pound deposit in a London bank. The
investor can earn greater interest income by keeping funds in dollars and, therefore,
one might expect all of his funds to flow to US banks. However, exchange rate
expectations also come into play. Suppose the investor expects the British pound to
appreciate at the rate of 2% in terms of dollar. That investor would then be
indifferent to either investment choices, as both are expected to earn 6%.
It’s a component of some economic theories and it’s a technique to determine the
relative value of different currencies. The concept of Purchasing Power Parity (PPP)
allows one to estimate what the exchange rate between two countries would have to
be in order for the exchange to be at par with the purchasing power of the two
countries’ currencies.
Using PPP rate for hypothetical currency conversions, a given amount of one
currency thus has the same purchasing power whether used directly to purchase a
market basket of goods or used to convert at the PPP rate to the other currency
and then purchase the market basket using the currency. Observed deviations of the
exchange rate from purchasing power parity are measured by deviation of the real
exchange rate from its PPP value of 1.
PPP exchange rate helps to minimise misleading international comparisons that can
arise with the use of market exchange rates. The PPP exchange rate serves two
main functions:
 PPP exchange rates can be useful for making comparisons between countries.
 Over a period of years, exchange rates do tend to move in the general
direction of the PPP exchange rate.

4. I R P & P P P P a g e | 3
In Simple with examples:-
The theory of Purchasing Power Parity postulates the foreign exchange rates should
be evaluated by the relative prices of a similar basket of goods between two nations.
A possible change in the rate of inflation in a given country should be balanced byt
the opposite change of country exchange rate. If prices in the country are surging
because of inflation, country’s exchange rate should decrease in order to return to
parity. PPP expresses the idea that a bundle of good in one country should cast the
same in another country after exchange rates are taken into account.
Suppose that with existing relative prices and exchange rates, a basket of goods can
be purchased with fewer US dollars in Canada than in US. We would then expect US
consumers to buy those goods in Canada. Such actions would cause US dollars to be
sold in exchange for Canadian dollars. As a result, the US dollars would depreciate in
relation with the Canadian dollars. We would expect the currency depreciation to
continue until the bundle of goods cost the same in both countries.
...Thank You...
Sumit Kumar Das
95/MBA/130020
MBA (Major Finance, Minor Marketing)
Calcutta University – Alipur Campus