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. Forward Rate Agreement - FRA

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

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

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

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

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

    A parity condition stating that the difference in interest rates ...
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. Days Sales Of Inventory - DSI

    A financial measure of a company's performance that gives investors an idea of how long it takes a company to turn its inventory ...
  2. Accounts Payable - AP

    An accounting entry that represents an entity's obligation to pay off a short-term debt to its creditors. The accounts payable ...
  3. Ratio Analysis

    Quantitative analysis of information contained in a company’s financial statements. Ratio analysis is based on line items ...
  4. Days Payable Outstanding - DPO

    A company's average payable period. Calculated as: ending accounts payable / (cost of sales/number of days).
  5. Net Sales

    The amount of sales generated by a company after the deduction of returns, allowances for damaged or missing goods and any ...
  6. Over The Counter

    A security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, etc. The phrase "over-the-counter" ...
Trading Center