Forex exam Essay Example | Topics and Well Written Essays - 1500 words

Forex exam - Essay Example (Baillie, R & McMahon, P, 1990). Covered Interest Parity is also known as â€Å"Interest Rate Parity†. This theory is based on the assumption that in an effective market with no transaction cost, the interest difference should be equal to the forward differential. The currency of the country with a lower interest should be at forward premium in term of the currency of the country with the higher interest rate. When this condition is met, the forward mark is said to be at interest parity and equilibrium prevail in the market. Condition for Covered Interest Parity is as follow: The uncovered interest parity propagates that the interest rate differential is equal to the ex-post exchange rate change. Uncovered Interest Parity theory is more difficult to test as because expected exchange rate changes are unobservable, also assumes that there should be no transaction cost, perfect capital flow, equal default risk on foreign and on domestic market. The risk premium should be zero. It is s follow: As all of these theories are based on certain assumption like the market condition has to be perfect, there should be no restriction on free trade, no transaction cost should exist and the investors should be risk neutral. But in the real world, market conditions are not perfect neither free trade is possible. In many countries government imposes certain restriction on import and export of goods for economical welfare of their country. Transaction cost exists in the real world and the investors are not risk neutral; rather the investors are risk averse. So these theories do not hold in the real world. Foreign exchange market has to play a very vital role in the present globalized world. Foreign currency is the life blood which gets exchanged through foreign exchange market. There are many factors which affect the foreign exchange market directly or indirectly and bring efficiency in this market which are as