Rationale Behind Interest Rate Parity

What is the reason behind Interest Rate parity?

It states : The currency which yield more should be at a forward discount in the forex market approximately the interest rate differential, such that when you sell the forward to complete the transaction, you won’t be able to make any profit.

But why does this happen?

For example, in Relative PPP, it’s common sense that the currency with a higher inflation would depreciate more and thus should depreciate on a net basis.

So the country with a higher inflation would depreciate more such that you can’t do any commodity arbitrage consistently.

But in interest rate parity, suppose everyone is investing in the currency with the higher interest rate, but that increases the demand of that currency even further and reduces the supply of the counter currency in that pair, meaning if Australia is providing 7% interest as compared to Japan (say 1%),

Everybody would sell Japanese Yen to convert to AUD, that increases the supply of the Yen and increases the demand of AUD.

JPY → Increased Supply, more selling pressure, therefore should depreciate

AUD → Increased Demand (everyone wants higher interest), more buying pressure, therefore should appreciate.

But according to interest rate parity, the currency with the higher interest rate (AUD) would be at a forward discount (meaning expected to depreciate during the maturity).

What am I missing here?

To prevent arbitrage.

No, that’s not what it means.

Forward rates are not meant to predict future spot rates.

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