Loading the player...

What is the 'Interest Rate Parity'

Interest rate parity is 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.

BREAKING DOWN 'Interest Rate Parity'

If one country offers a higher risk-free rate of return in one currency than that of another, the country that offers the higher risk-free rate of return will be exchanged at a more expensive future price than the current spot price. In other words, the interest rate parity presents an idea that there is no arbitrage in the foreign exchange markets. Investors cannot lock in the current exchange rate in one currency for a lower price and then purchase another currency from a country offering a higher interest rate.

Covered vs. Uncovered Interest Rate Parity

The interest rate parity is said to be covered when the no-arbitrage condition could be satisfied through the use of forward contracts in an attempt to hedge against foreign exchange risk. Conversely, the interest rate parity is said to be uncovered when the no-arbitrage condition could be satisfied without the use of forward contracts to hedge against foreign exchange risk.

Options of Converting Currencies

The relationship can be seen in the two methods an investor may take to convert foreign currency into U.S. dollars.

One option an investor may take 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.

The second option 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.

Covered Interest Rate Parity Example

For example, assume Australian Treasury bills are offering an annual interest rate of 1.75%, while U.S. Treasury bills are offering an annual interest rate of 0.5%. If an investor in the United States seeks to take advantage of the interest rates in Australia, the investor would have to translate U.S. dollars to Australian dollars to purchase the Treasury bill. Thereafter, the investor would have to sell a one-year forward contract on the Australian dollar. However, under the covered interest rate parity, the transaction would only have a return of 0.5%, or else the no-arbitrage condition would be violated.

RELATED TERMS
  1. Covered Interest Rate Parity

    This term refers to a condition where the relationship between ...
  2. Uncovered Interest Rate Parity ...

    A parity condition stating that the difference in interest rates ...
  3. Parity

    1. In general, a situation of equality. Parity can occur in many ...
  4. Forward Premium

    When dealing with foreign exchange (FX), a situation where the ...
  5. International Currency Exchange ...

    The rate at which two currencies in the market can be exchanged. ...
  6. Uncovered Interest Arbitrage

    A form of arbitrage that involves switching from a domestic currency ...
Related Articles
  1. Trading

    Using Interest Rate Parity To Trade Forex

    Learn the basics of forward exchange rates and hedging strategies to understand interest rate parity.
  2. Investing

    Explaining Interest Rate Parity

    Interest rate parity exists when the expected nominal rates are the same for both domestic and foreign assets.
  3. Investing

    Explaining Uncovered Interest Rate Parity

    Uncovered interest rate parity is when the difference in interest rates between two nations is equal to the expected change in exchange rates.
  4. Trading

    6 Factors That Influence Exchange Rates

    An in depth look at out how a currency's relative value reflects a country's economic health and impacts your investment returns.
  5. Investing

    Explaining Foreign Exchange Risk

    Foreign exchange risk is the chance that an investment’s value will decrease due to changes in currency exchange rates.
  6. Trading

    The Money Market Hedge: How It Works

    Investopedia explains how to hedge foreign exchange risk using the money market, the financial market in which highly liquid and short-term instruments like Treasury bills, bankers’ acceptances ...
  7. Trading

    How To Lock In An Exchange Rate

    Currency risk can be effectively hedged by locking in an exchange rate through the use of currency futures, forwards, options, or exchange-traded funds.
  8. Investing

    Explaining Fixed Exchange Rates

    A government using a fixed exchange rate has linked the value of its currency to the value of another country’s currency, or the price of gold.
  9. Trading

    Dual And Multiple Exchange Rates 101

    Why would a country choose to implement dual or multiple exchange rates? It's risky, but it can work.
RELATED FAQS
  1. How can I invest in a foreign exchange market?

    The foreign exchange market, also called the currency market or forex (FX), is the world's largest financial market, accounting ... Read Answer >>
  2. How do changes in national interest rates affect a currency's value and exchange ...

    Understand the role that changes in interest rates can play in determining the value and foreign exchange rate of a country's ... Read Answer >>
  3. How does inflation affect the exchange rate between two nations?

    Understand how inflation can affect foreign exchange rates of a currency and how it is just one of many economic factors ... Read Answer >>
  4. How do I convert a spot rate to a forward rate?

    Learn how to convert spot rates to forward rates for financial transactions agreed to today but not to be executed until ... Read Answer >>
  5. Is risk parity a safe investment strategy?

    Learn how risk parity funds won't blow away the market, but will grow steadily over time by using the time-tested strategies ... Read Answer >>
  6. What types of companies benefit from reporting results utilizing constant currencies ...

    Understand constant currency figures, and explore some of the reasons why a company is likely to benefit from reporting using ... Read Answer >>
Hot Definitions
  1. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  2. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  3. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
  4. Job Market

    A market in which employers search for employees and employees search for jobs. The job market is not a physical place as ...
  5. Yuppie

    Yuppie is a slang term denoting the market segment of young urban professionals. A yuppie is often characterized by youth, ...
  6. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
Trading Center