An Analysis of Exchange Rate Based on Interest Rate Parity Theory

Interest rate parity states that the forward premium of a foreign currency should equal the interest rate differential between a domestic asset and a substitutable foreign asset. Thus, interest rate parity describes how the interest rate and the forward exchange rate both affect exchange rate. In this paper, assuming the relationship between the forward exchange rate and stock price index, we construct a new analytical model of the exchange rate. The model is tested empirically using data of five major developed countries relative to the US during the European debt crisis. We identify the main determinants of the exchange rates of these developed countries.