What is interest rate parity

Table of Contents Expand. Table of Contents. What Is Interest Rate Parity? Covered vs. Uncovered Interest Parity. Why Interest Rate Parity Matters. By Tim Lemke. Tim Lemke has more than 20 years of experience as a writer. He specializes in writing about investing, cryptocurrency, stocks, banking, business, and more. In , he joined investment management company T.

Rowe Price as a senior writer. Learn about our editorial policies. Note With interest rate parity, it doesn't matter whether a person invests money and converts the earnings to another currency first, or converts the money and then invests it. Key Takeaways Interest rate parity is a theory that suggests a strong relationship between interest rates and the movement of currency values.

The two key exchange rates are the "spot" rate and the "forward" rate. The spot rate is the current exchange rate, and the forward rate is the rate that a bank agrees to exchange one currency for another in the future.

Your Money. Personal Finance. Your Practice. Popular Courses. Part Of. Basic Forex Overview. Key Forex Concepts. Currency Markets. Advanced Forex Trading Strategies and Concepts. Table of Contents Expand. Calculating Forward Rates. Covered Interest Rate Parity. Covered Interest Rate Arbitrage. Uncovered Interest Rate Parity.

IRP Between the U. Hedging Exchange Risk. The Bottom Line. Key Takeaways Interest rate parity is the fundamental equation that governs the relationship between interest rates and currency exchange rates. Parity is used by forex traders to find arbitrage or other trading opportunities. Article Sources. Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts.

We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear.

Investopedia does not include all offers available in the marketplace. Related Articles. Partner Links. Understanding Uncovered Interest Rate Parity — UIP Uncovered interest rate parity UIP states that the difference in two countries' interest rates is equal to the expected changes between the two countries' currency exchange rates. For enterprise. Both interest rates and currency rates vary from one country to the next. Interest rate parity is a theory that helps resolve the balance between these two figures when investing.

Interest rate parity IRP is an equation used to manage the relationship between currency exchange and interest rates. The fundamental concept behind the IRP is that the interest rate differential between two countries will be equal to the differential between the spot exchange rate and the forward exchange rate.

When you invest in different currencies, the hedged returns should be the same regardless of fluctuations in interest rates. The forward exchange rate should equal the spot currency exchange rate multiplied by the interest rate of the home country, then divided by the foreign currency interest rate.

Interest rate parity is also behind the no-arbitrage concept. In foreign exchange markets, this refers to the purchase and sale of a single asset enabling a trader to benefit from price differences. Uncovered and covered interest rate parity look similar, the only difference being the use of forward contracts.

The investor agrees to invest the foreign currency AUD in this case locally at a risk-free foreign rate. He enters a forward rate agreement, which states he will convert any proceeds at the end of the investing period into GBP at the forward exchange rate.

In the case of interest parities, what are equalized are the rates of return across various interest-bearing financial instruments bank deposits, bonds, bills, etc. Under free capital mobility, LOOP holds firmly and trivially for covered interest parity, but the validity of LOOP for uncovered interest parity is empirically very questionable. The difference is explained by the absence or presence of exchange risk see below.

The above are necessary conditions for covered interest parity. There are no exchange, default or other risks related to financial investment. We are assuming a perfectly safe, risk-free world. Here, exchange risk is present although all other risks of financial investment are still assumed away. Investors are assumed to be neutral against this risk.

That means they care only about the average results. Whether the variance volatility of the return of each investment is large or small does not concern them. Covered and uncovered interest parities should not be confused with each other.

They refer to two completely different situations. When people and firms are permitted to buy and sell foreign assets, they can hold various exchange "positions," which are net holding balances in foreign currency. The positions are classified below. For simplicity, we assume all foreign assets and liabilities are denominated in USD. This allows us to concentrate on the movement of the domestic currency against USD, without worrying about the fluctuations among major currencies.

Suppose you are a manufacturer of a certain product and also engaged in foreign trade. As you conduct your daily transactions of buying foreign parts or exporting finished products to foreign markets, the exchange position naturally fluctuates and does not remain "square.

Suppose also that your main business is manufacturing and you are not interested in foreign currency speculation. Particularly, you want to avoid exchange losses. If your country has sufficiently developed and externally open financial markets, there are two alternative ways to "cover" or "hedge"--i. You want to fix this receipt in terms of yen domestic currency now.

Suppose also that:. The first method is forward cover. You go to a bank and make a forward contract today. Then you wait for 3 months before executing this transaction.

The exchange rate for selling USD in the future forward rate, , offered by the bank, is different from the exchange rate for today spot rate, The second method is borrow dollar and sell spot now.

Either way, you fix the yen receipt as of today so there is no exchange risk. But with the assumptions illustrated above, forward cover yields 10, yen and the borrowing method yields only 9, yen. Clearly, everyone prefers the first method.