Using Interest Rate Parity to Trade Forex involves determining the forward and spot interest rates for two currencies. This can help you decide which currencies to buy and sell in order to maximize your profits. By studying these differences between countries, you can determine which one has the most favorable exchange rate for your investments. When using interest rate parity, investors should make sure they use the same currency pair. That way, they can have a consistent advantage over each other.
The interest rate parity model is most effective when an investor invests in his own country first and then transfers the earnings into another currency. Because interest rates are interrelated with forward currency rates, the investor makes the same amount of money either way. It is important to note that interest rates are inversely related to forward currencies. For example, an investor in the United States might invest in the Japanese yen at a rate of 2%, while the investor in Japan will invest in a rate of 1.6%. In both cases, the interest rate on the USD should increase by 3%.
If interest rates were high, the approximate interest rate formula would not provide an accurate representation of the rates of return. In other words, if the short-term interest rate in Russia was 75 percent, the corresponding yield would only be around 60 percent. Fortunately, the two currencies’ exchange rates do not change much, making interest rate parity a key concept in trading forex. To make money with Forex, you need to understand interest rate parity. To trade currencies, you need to understand the forward and spot exchange rates.