The Interest Parity Condition

Now that the capital markets are pretty much globalised, and will only get ever more so in a technologically advanced modern society, this ensures that returns across the different markets in most circumstances are equalised.

This makes sense if you think about it. If one market were, for instance, to offer a higher return for the same amount of risk as presented by another one of the markets operating elsewhere, then it would make sense for everyone to move their money - were they aware of the other offering - into that offering, as it makes sense to move from a lower yield to a higher one if there is no increase in risk.

What this therefore means is that it would cause the yields in the larger market to drop off and the lower yielding one would rise up as a result, and so this leads back to an equilibrium situation, through the movement of the exchange rate that there is between the two economies.

This can easily be seen by putting a few numbers in for instance imagining a specific return rate in the UK versus the US dollar, and then see what happens when the exchange rate changes what happens to the expected retun in the two systems.

Try it with some simple figures and see what happens and how it works to bring about the equilibrium between different yields in the two markets.

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