... insures interest rate parity because this relationship prevents speculators from profiting by borrowing in a low interest rate country and simultaneously lending in a high interest rate country and hedging the currency risk. Covered interest rate parity Covered interest parity: interest rates denominated in different currencies are the same once you "cover'' yourself against possible currency changes. The argument follows the standard logic of arbitrage in finance. Consider two relatively riskless strategies for investing a Dollar for one year: 1. Invest dollar in US deposit. After one year, you have (1+i) dollars where i is the dollar rate of interest. 2. Alternate strategy has several steps: o Convert the $ to DM, giving e DMs where e is the spot exchange rate. o Invest the money in a DM deposit, earning if which leaves you with (1+if)e DMs at the end of the year. o We could convert back to $ ...

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