What does Interest Rate Parity (IRP) imply about exchange rates and interest rates?

• A. The expected change in exchange rates equals the nominal interest rate differential; arbitrage opportunities exist.
• B. The expected change in exchange rates is unpredictable even with differential.
• C. The expected change in exchange rates equals the interest rate differential; no arbitrage opportunities exist.
• D. Interest rates and exchange rates move independently.

Answer: (C)

Interest Rate Parity ties together how much returns differ between currencies and how those currencies are expected to move. The essential idea is that the expected change in the exchange rate should offset the difference in interest rates between two countries so that, after converting currencies, you earn the same return whether you invest domestically or abroad. When we talk about the uncovered version, this means if the domestic interest rate is higher, the domestic currency should be expected to depreciate by about that differential. That alignment makes arbitrage impossible: borrowing in the cheaper currency, converting, and investing in the higher-yield asset would not yield a risk-free profit once the expected currency move is taken into account. If the expected exchange rate move didn’t match the interest rate gap, investors would exploit the mismatch, and that activity would push markets toward parity. So the statement that the expected change in exchange rates equals the interest rate differential and that no arbitrage opportunities exist is the correct intuition.