Mechanism of Monetary Transmission

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Mechanism of Monetary Transmission

By | September 2008
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This article does not cite any references or sources. (November 2007) Please help improve this article by adding citations to reliable sources. Unverifiable material may be challenged and removed. The interest rate parity is the basic identity that relates interest rates and exchange rates. The identity is theoretical, and usually follows from assumptions imposed in economics models. There is evidence that supports as well as rejects interest rate parity. Interest rate parity is an arbitrage condition which says that the returns from borrowing in one currency, exchanging that currency for another currency and investing in interest-bearing instruments of the second currency, while simultaneously purchasing futures contracts to convert the currency back at the end of the investment period, should be equal to the returns from purchasing and holding similar interest-bearing instruments of the first currency. If the returns are different, investors could theoretically arbitrage and make risk-free returns. Looked at differently, interest rate parity says that the spot and future prices for currency trades incorporate any interest rate differentials between the two currencies. Two versions of the identity are commonly presented in academic literature: covered interest rate parity and uncovered interest rate parity. Contents

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1 Covered interest rate parity
o1.1 An example
2 Uncovered interest rate parity
o2.1 Uncovered interest parity example
o2.2 Uncovered vs. covered interest parity example
3 Cost of carry model

[edit] Covered interest rate parity
Covered interest parity (also called interest parity condition) means that the following equation holds:
where:
is the domestic interest rate implied by debt of a given maturity; •ic is the interest rate in the foreign country for debt of...
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