The theory of interest rate parity states that the annual percentage differential in the forward market for a currency quoted in terms of another currency is equal to the approximate difference in ____ rates prevailing in the two countries.

Question

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The theory of interest rate parity suggests that the difference between the forward exchange rate and the spot exchange rate for a currency pair is equal to the interest rate differential between the two countries. This means that if Country A has a higher interest rate than Country B, the forward exchange rate for Country A's currency will be higher than the spot exchange rate, to compensate for the additional interest that can be earned by investing in the higher-yielding currency. Thus, interest rates are the key factor in interest rate parity, not inflation, trade deficit, or GNP growth.

The Theory of Interest Rate Parity States That the Annual