Interest Rate Parity

AAA

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 risk-free 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.) risk-free rate. When no arbitrage opportunities exist, the cash flows from both options are equal.

RELATED TERMS
  1. Risk-Free Rate Of Return

    The theoretical rate of return of an investment with zero risk. ...
  2. Spot Exchange Rate

    The rate of a foreign-exchange contract for immediate delivery. ...
  3. Uncovered Interest Rate Parity ...

    A parity condition stating that the difference in interest rates ...
  4. Interest Rate Differential - IRD

    A differential measuring the gap in interest rates between two ...
  5. Arbitrage

    The simultaneous purchase and sale of an asset in order to profit ...
  6. Forward Rate

    A rate applicable to a financial transaction that will take place ...
Related Articles
  1. thinkstock|istock
    Options & Futures

    A Primer On The Forex Market

  2. Economics

    Forces Behind Interest Rates

  3. Forex Education

    Getting Started In Foreign Exchange ...

  4. Options & Futures

    Trading The Odds With Arbitrage

Hot Definitions
  1. Capitulation

    When investors give up any previous gains in stock price by selling equities in an effort to get out of the market and into ...
  2. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  3. Conduit Issuer

    An organization, usually a government agency, that issues municipal securities to raise capital for revenue-generating projects ...
  4. Financing Entity

    The party in a financing arrangement that provides money, property, or another asset to an intermediate entity or financed ...
  5. Hyperinflation

    Extremely rapid or out of control inflation. There is no precise numerical definition to hyperinflation. Hyperinflation is ...
  6. Gross Rate Of Return

    The total rate of return on an investment before the deduction of any fees or expenses. The gross rate of return is quoted ...
Trading Center