The Interest Rate Parity Condition

Interest rate parity (IRP) holds when the rate of return on dollar deposits is just equal to the expected rate of return on British deposits, i.e.,

Plugging in the above formulae yields,

This condition is often simplified in many textbooks by dropping the final British interest term. The logic, I guess, is that the final term does not change the rate of return value dramatically and it is easier to provide intuition. The approximate version of the IRP condition then is,

One should be careful however. The approximate version would not be a good approximation when interest rates in a country are high. For example, back in 1997 short term interest rates in Russia were 60% per year, in Turkey they were 75% per year. With these interest rates the approximate formula would not give an accurate representation of rates of return.

International Finance Theory and Policy - Chapter 20-1: Last Updated on 12/29/05