DEFINITION of 'Interest Rate Parity'
A theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. Interest rate parity plays an essential role in foreign exchange markets, connecting interest rates, spot exchange rates and foreign exchange rates.
INVESTOPEDIA EXPLAINS 'Interest Rate Parity'
The relationship can be seen when you follow the two methods an investor may take to convert foreign currency into U.S. dollars.
Option A would be to invest the foreign currency locally at the foreign riskfree rate for a specific time period. The investor would then simultaneously enter into a forward rate agreement to convert the proceeds from the investment into U.S. dollars, using a forward exchange rate, at the end of the investing period.
Option B would be to convert the foreign currency to U.S. dollars at the spot exchange rate, then invest the dollars for the same amount of time as in option A, at the local (U.S.) riskfree rate. When no arbitrage opportunities exist, the cash flows from both options are equal.

Forward Rate Agreement  FRA
An overthecounter contract between parties that determines ... 
Forward Rate
A rate applicable to a financial transaction that will take place ... 
Spot Exchange Rate
The rate of a foreignexchange contract for immediate delivery. ... 
RiskFree Rate Of Return
The theoretical rate of return of an investment with zero risk. ... 
Interest Rate Swap
An agreement between two parties (known as counterparties) where ... 
Interest Rate
The amount charged, expressed as a percentage of principal, by ...

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