Forex parity level, also known as exchange rate parity, is the value at which two currencies are equal to each other. It is the exchange rate at which one currency can be exchanged for another currency. In other words, it is the ratio of one currency to another. The concept of forex parity level is important in international trading, as it helps to determine the value of a currency in relation to another currency.
There are two types of forex parity levels, namely, purchasing power parity (PPP) and interest rate parity (IRP). Let’s take a closer look at each of them.
Purchasing Power Parity (PPP)
PPP is a theory that suggests that exchange rates should adjust so that the same basket of goods and services has the same price in different countries. In other words, PPP suggests that the exchange rate between two currencies should equal the ratio of the price levels of a basket of goods and services in the two countries.
For example, let’s say that a basket of goods and services costs $100 in the United States and €80 in Europe. The exchange rate between the two currencies should be such that $1 equals €0.80. If the exchange rate is different, then there is an opportunity for arbitrage, i.e., buying goods in the cheaper country and selling them in the more expensive country, thus earning a profit.
Interest Rate Parity (IRP)
IRP is a theory that suggests that the interest rate differential between two currencies should be equal to the percentage difference between the forward exchange rate and the spot exchange rate. In other words, IRP suggests that the interest rate differential between two currencies should be equal to the expected change in the exchange rate over the same period.
For example, let’s say that the interest rate in the United States is 2% and the interest rate in Europe is 1%. If the expected change in the exchange rate between the two currencies over the next year is 1%, then the forward exchange rate should be such that the interest rate differential is equal to the expected change in the exchange rate.
Why is Forex Parity Level Important?
Forex parity level is important because it helps to determine the value of a currency in relation to another currency. It is also important for international trade, as it helps to determine the exchange rate at which goods and services are traded between countries.
Moreover, forex parity level is important for investors who are looking to invest in foreign currencies. Understanding forex parity level can help investors to make informed decisions about when to buy or sell a currency, and how much to invest.
Conclusion
Forex parity level is the value at which two currencies are equal to each other. There are two types of forex parity levels, namely, purchasing power parity (PPP) and interest rate parity (IRP). PPP suggests that exchange rates should adjust so that the same basket of goods and services has the same price in different countries, while IRP suggests that the interest rate differential between two currencies should be equal to the expected change in the exchange rate over the same period.
Forex parity level is important for international trade and investors who are looking to invest in foreign currencies. Understanding forex parity level can help investors to make informed decisions about when to buy or sell a currency, and how much to invest.
