Given the interest rate on a 1-year loan is 14.5 per cent and inflation is expected to be 6.5 per cent in India. What should be the interest rate on a 1-year maturity loan in Thailand when the expected inflation rate is 8.5 per cent ? 

Interest Rate Parity Theory:

• Interest Rate Parity (IRP) is a theory where the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.
• According to IRP, at equilibrium, the forward rate of a foreign currency will differ from the current spot rate by an amount that will equal the interest rate differential between the home and foreign country.
• As a result of market forces, the forward rate differs from the spot rate by an amount that sufficiently offsets the interest rate difference between the two countries.
• Then covered interest arbitrage is no longer feasible, and the equilibrium state achieved is referred to as Interest Rate Parity (IRP).

Solution:

• Interest rate = [(1 + interest rate) / (1 + inflation rate of India)] * (1 + inflation rate of Thailand)
• = [(1 + 0.145) / (1 + 0.065)] * (1 + 0.085)
• = (1.145 / 1.065) * 1.085
• = 1.075 * 1.085
• = 1.665
• = 16.65%.

Therefore, the interest rate on a 1-year maturity loan in Thailand will be 16.65%.