A Note on Interest Parity and the Supply of Arbitrage Funds

The divergence of the actual forward premium on foreign exchange from that dictated by the principle of interest rate parity can arise from two separately identifiable causes: (1) an equilibrium position as indicated by the interest parity principle has not been reached, or (2) that the principle itself is not a correctly specified equilibrium condition. It is the purpose of this note to offer a revised specification of the interest parity condition and to determine whether this version approximates more closely the actual premium as determined in the market. It should be made clear however, that this is a partial analysis and does not deal with the impact of other forces (for example, speculation) on the forward premium. As a result, a complete model of the spot and forward markets for foreign exchange, such as Stein's (1965), is not attempted here. In general, the principle of interest parity maintains that, in equilibrium,