For a moment, lets assume a world made up of two countries, U.S. and Canada, where Canada is in fact a top trading partner of the U.S. The exchange rate between the two currencies, US$ / Can$ is approximately 1.2602, as of today. In other words, it takes USD1.2602 to purchase a Canadian dollar.
Lets also assume that there is no capital control and one can move money freely. I have two options: Invest my money in a U.S Series EE Bonds that has a rate of return of 0.1% annualy or, convert my US dollars into Canadian dollars and invest in, say, Canada Premium Bonds Series that clearly has a higher return of 1% annually.
Well according to Interest Rate Parity, interest rates (savings yield) will adjust so that a person is indifferent between holding U.S dollars or Canadian dollars, or assets denominated in U.S dollars/Canadian dollars.
Lets work out this example and se if IRP holds and if no, what does it take to ensure it does. We start with 1 U.S. dollar as our initial investment portfolio. Given the current exchange rate of US$/Can$=1.2602, we will end up with Can$0.7935.
We invest Can$0.7395 into a Canadian Premium Bond that offers a return of 1% annually. AT the end of the year, we have Can$ 0.7935(1+1/100)^1=Can$0.8014
Now, lets convert that amount back to U.S. dollars. Can$0.08014 = US$1.0099.
Can we do better ( or worse) if we invested the dollar in a U.S. EE bonds instead of the Canadian one?
1 US$ invested in a bond that pays a return of 0.1% gives us 1(1+0.1/100)^1= US$1.001
So, it turns out that we are slightly better off investing our money in a Canadian bond by 1.0099-1.001=0.0089 cents!
What should the U.S. interest rate be so as to prevent capital flight from the U.S. to Canada? In other words, 1US$ ( 1+r/100)= 1.0099, at the very least. r turns out to be 0.99 % or at least 9.9 times higher than the current one.
This is a simplistic view of IRP and capital flight with 2-country world. Do you believe that IRP holds true in the real world? Are there any strong evidence, or the lack there of, that currency arbitraging does indeed happen between world currencies?