Which statement accurately reflects the concept of interest rate parity?

The concept of interest rate parity fundamentally describes the relationship between interest rates and currency exchange rates. It suggests that the difference in nominal interest rates between two countries is equal to the expected change in exchange rates between their currencies. This means that if one country has a higher interest rate, its currency is expected to depreciate in the future to offset the benefits of that higher interest rate.

For instance, if investors can earn higher interest in one country compared to another, the higher returns can attract foreign investment. However, as money moves into this higher-interest-rate country, the demand for its currency will increase, leading to appreciation. To maintain equilibrium, the future spot rate will adjust downward to reflect this imbalance caused by the different interest rates.

Thus, the correct statement accurately encapsulates the essence of interest rate parity, highlighting that the discrepancies in interest rates will be balanced out through corresponding movements in exchange rates, ensuring no arbitrage opportunities arise from the difference. This principle is vital for understanding currency markets and cross-border investments.