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. Arbitrage

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

    A rate applicable to a financial transaction that will take place ...
  3. Forward Rate Agreement - FRA

    An over-the-counter contract between parties that determines ...
  4. Interest Rate

    The amount charged, expressed as a percentage of principal, by ...
  5. Interest Rate Swap

    An agreement between two parties (known as counterparties) where ...
  6. Risk-Free Rate Of Return

    The theoretical rate of return of an investment with zero risk. ...
Related Articles
  1. A Primer On The Forex Market
    Options & Futures

    A Primer On The Forex Market

  2. Forces Behind Interest Rates
    Economics

    Forces Behind Interest Rates

  3. Getting Started In Foreign Exchange ...
    Forex Education

    Getting Started In Foreign Exchange ...

  4. Trading The Odds With Arbitrage
    Options & Futures

    Trading The Odds With Arbitrage

comments powered by Disqus
Hot Definitions
  1. Halloween Massacre

    Canada's decision to tax all income trusts domiciled in Canada. In October 2006, Canada's minister of finance, Jim Flaherty, ...
  2. Zombies

    Companies that continue to operate even though they are insolvent or near bankruptcy. Zombies often become casualties to ...
  3. Witching Hour

    The last hour of stock trading between 3pm (when the bond market closes) and 4pm EST. Witching hour is typically controlled ...
  4. October Effect

    The theory that stocks tend to decline during the month of October. The October effect is considered mainly to be a psychological ...
  5. Repurchase Agreement - Repo

    A form of short-term borrowing for dealers in government securities.
  6. Correlation

    In the world of finance, a statistical measure of how two securities move in relation to each other. Correlations are used ...
Trading Center