What does interest rate parity suggest regarding currency exchange rates?

Interest rate parity is a fundamental concept in international finance that describes the relationship between interest rates and currency exchange rates. It suggests that the difference in interest rates between two countries will be reflected in the forward exchange rates of their currencies. Specifically, if one country has a higher interest rate compared to another, the currency of the country with the higher interest rate is expected to trade at a forward premium, while the currency of the country with the lower interest rate is expected to trade at a forward discount.

Choosing the answer that states the forward currency discount is influenced by interest rate differentials aligns perfectly with this theory. The relationship holds because if one currency offers higher returns due to higher interest rates, investors will demand that currency, impacting its forward rate in correlation to the expected returns.

The other choices do not accurately reflect the concept of interest rate parity. For instance, stating that exchange rates will always remain static disregards the dynamic nature of international finance where currencies are influenced continuously by various factors, including interest rates. Similarly, suggesting that the forward currency premium is unrelated to interest rates misses the core principle of how interest rates directly affect currency values. Lastly, the assertion that exchange rates fluctuate freely without considering interest rates fails to acknowledge that underlying interest differentials are crucial in shaping