It is often claimed that the forward exchange rate is set by arbitrage to satisfy (covered) interest rate parity
Explain how interest rate parity can be satisfied and how the forward exchange rate can be set by speculators in reference to the expected future spot exchange rate.
Interest rate parity is a no arbitrage relation between 4 variables, the spot and forward exchange rates and the interest rates on the two currencies. If the forward exchange rate is set by speculators in reference to the expected future spot exchange rate, the current spot rate or the two interest rates can adjust to satisfy interest rate parity. The speculative dimension of trading must also be satisfied in equilibrium.
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