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. Parity Price

    Parity price is a term used to explain when two assets are equal ...
  2. Risk Parity

    Risk parity is a portfolio allocation strategy using risk to ...
  3. Net Interest Rate Differential

    In international markets, the difference in the interest rates ...
  4. Parity Product

    A parity product is a brand of good that has enough similarities ...
  5. Currency Forward

    A binding contract in the foreign exchange market that locks ...
  6. Forward Premium

    A forward premium occurs when the expected future price of a ...
Related Articles
  1. Investing

    Explaining Interest Rate Parity

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

    6 factors that influence exchange rates

    Here, you'll get in-depth look at out how a currency's relative value reflects a country's economic health and impacts your investment returns.
  3. Trading

    The money market hedge: How it works

    Hedge foreign exchange risk using the money market, which includes Treasury bills, bankers’ acceptances and commercial paper.
  4. Insights

    Interest Rate Arbitrage Strategy: How It Works

    Changes in interest rates can give rise to arbitrage opportunities that, while short-lived, can be very lucrative for traders who capitalize on them.
  5. Trading

    Euro-Dollar Parity is Back

    With the euro hitting record lows against the dollar, market expectations are for euro-dollar parity in Q1, before the single currency finds support.
  6. 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.
  7. Trading

    Why Forward Contracts Are The Foundation Of All Derivatives

    This article expands on the complex structure of derivatives by explaining how an investor can assess interest rate parity and implement covered interest arbitrage by using a currency forward ...
  8. 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.
  9. Insights

    Exodus: Record Capital Rushes Out of Eurozone

    European investors have moved some $550 billion out of Europe this year, the biggest amount in 17 years
RELATED FAQS
  1. How do I convert a spot rate to a forward rate?

    The spot rate shows the cost of executing a financial transaction today, while the forward rate provides the cost of executing ... Read Answer >>
  2. How do national interest rates affect a currency's value and exchange rate?

    Generally, higher interest rates increase the value of a given country's currency, but Interest rates alone do not determine ... Read Answer >>
  3. How are international exchange rates set?

    Knowing the value of your home currency in relation to different foreign currencies helps investors to analyze investments ... Read Answer >>
  4. 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 >>
Hot Definitions
  1. Capital Asset Pricing Model - CAPM

    Capital Asset Pricing Model (CAPM) is a model that describes the relationship between risk and expected return and that is ...
  2. Return On Equity - ROE

    The profitability returned in direct relation to shareholders' investments is called the return on equity.
  3. Working Capital

    Working capital, also known as net working capital is a measure of a company's liquidity and operational efficiency.
  4. Bond

    A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows ...
  5. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
  6. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
Trading Center