Loading the player...

What is '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.

  1. Parity

    Parity refers to things being equal to each other. It can thus ...
  2. Parity Product

    A parity product is a brand of good that has enough similarities ...
  3. Risk Parity

    Risk parity is a portfolio allocation strategy using risk to ...
  4. Relative Purchasing Power Parity ...

    Relative Purchasing Power Parity (RPPP) is the view that inflation ...
  5. Net Interest Rate Differential

    In international markets, the difference in the interest rates ...
  6. Parity Bond

    Parity bonds are two or more bond issues with equal rights of ...
Related Articles
  1. Trading

    6 factors that influence exchange rates

    Aside from interest rates and inflation, the exchange rate is one of the most important determinants of a country's level of economic health.
  2. Investing

    How to Create a Risk Parity Portfolio

    Learn about how risk parity uses leverage to create equal exposure to risk among different asset classes in portfolio construction.
  3. Insights

    What Is Purchasing Power Parity (PPP)?

    Purchasing power parity (PPP) is an economic theory that compares different countries' currencies through a "basket of goods" approach.
  4. Trading

    Interest Rate and Currency Value And Exchange Rate

    In general, higher interest rates in one country tend to increase the value of its currency.
  5. Investing

    What Investors Should Know About Interest Rates

    Understanding interest rates helps you answer the fundamental question of where to put your money. Learn about the relationship between rates and stocks.
  6. Trading

    How to Calculate an Exchange Rate

    Struggling to get a grasp on exchange rates? Here's what you need to know.
  7. Insights

    How US Interest Rates Move the World Economy

    Because the US has the world's largest economy, fluctuations in America's interest rates affect much more than domestic growth
  8. Trading

    Understand the Indirect Effects of Exchange Rates

    Exchange rates have a tremendous influence on the economy. Exchange rates can indirectly affect many of the most important aspects of our lives.
  1. What is the Difference Between a Forward Rate and a Spot Rate?

    The forward rate is the settlement price of a forward contract, while the spot rate is the settlement price of a spot contract. Read Answer >>
  2. What indicators are used in exchange rate forecasting?

    Learn what economic indicators are most widely used to forecast a country’s exchange rate and how various foreign exchange ... Read Answer >>
  3. What is foreign exchange?

    Foreign exchange is the conversion of a country's currency into another. In a free economy, a country's currency is valued ... Read Answer >>
  4. What is a forward contract against an export?

    Understand forward exchange contracts in exporting, and learn the purpose of using a forward contract and its advantages ... Read Answer >>
Trading Center