Interest rate parity

One step forward in my quest on what moves interest ratesinterest rate parity. Simply put, this theory states that

the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.

In other words, the total sum (principal + interest) in currency A at the end of a given time period should equal the total sum if currency A is first converted into currency B, invested for interest, and converted back to currency A at the end of the same period.

This is one reason behind lower interest rates in Singapore, as the Singapore dollar has appreciated against the US dollar over the last one year. The interest rate parity theory can only be used as a guide though. As explained in this article, Singapore interest rates have been lower than the implied rates from the interest-parity modelling:

Singapore’s domestic short-term interest rates have since April [2007]stayed below the implied short-term rates suggested by our equilibrium interest-parity modelling. We suspect that this reflects a deliberate strategy by the MAS to maintain enough liquidity in the local system to keep domestic interest rates low and shield the Singapore dollar from becoming a target currency for the yen carry trade.

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