Currency Markets and International Interest Rate Parity

Abstract

In this chapter the authors seek to provide a general overview of the international markets for foreign exchange (FX) and FX derivatives as well as the theoretical relationships that tie these markets together with interest rates and central bank policies. The first section provides a brief summary of the FX markets, leading up to an illustration of their current size and uses. The second section details and distinguishes the various markets and FX products. This section also takes a close look at the FX derivative markets and presents the Garman and Kohlhagen pricing model. The third section presents the theoretical relationships between returns, exchange rates and interest rates specifically examining equilibrium conditions and the Taylor rule. Finally, the fourth section reviews several recent developments in the global currency markets.

Keywords: Foreign Exchange Markets, Currency Forward Market, Currency Futures, Foreign Currency Options, Interest Rate Parity, Federal Policies and Currency Markets, Taylor Rule