Next video:
Loading the player...

The economic theory of interest rate parity states that the difference between the interest rate in two countries is equal to the differential between the forward rate and the spot rate of those two countries. This equality does not always exist, and thus allows traders to arbitrage option positions to earn riskless returns. 

For interest rate parity to exist, there must be easy capital mobility between countries, along with complete substitutability of assets. For instance, a deposit in a foreign bank is considered the same as a deposit in a domestic bank. If the nominal returns were different between the domestic and foreign deposits, investors would move their money to the bank paying the higher nominal return.

Interest rate parity exists when the expected nominal rates are the same for both domestic and foreign assets. Any difference is due to expected appreciation or deprecation in the foreign or domestic currencies.  For instance, if the domestic interest rate is 8%, and the foreign interest rate is 5%, this means that the market expects the foreign currency to appreciate by 3%, or conversely, investors expect the domestic currency to depreciate by 3%.

In that scenario, it doesn’t matter if an investor invests in a timed foreign deposit and then converts the foreign currency to his domestic currency, or invests in a timed domestic deposit and then converts the domestic currency to the foreign currency. With interest rate parity, either option produces the exact same cash flow.

Related Articles
  1. Insights

    Purchasing Power Parity (PPP)

    Purchasing Power Parity (PPP) compares different countries' currencies through a market "basket of goods" approach. Two currencies are in PPP when a market basket of goods (taking into account ...
  2. Investing

    Protect Your Foreign Investments From Currency Risk

    Hedging against currency risk can add a level of safety to your offshore investments.
  3. Trading

    The International Fisher Effect: An Introduction

    The Fisher models have the ability to illustrate the expected relationship between interest rates, inflation and exchange rates.
  4. 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.
  5. Trading

    The Effects Of Currency Fluctuations On The Economy

    Currency fluctuations are a natural outcome of the floating exchange rate system that is the norm for most major economies.
  6. Investing

    Broadening Your Portfolio's Borders

    Find out what type of international fund might suit your needs in gaining exposure to foreign markets.
  7. 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.
  8. Insights

    Cautionary Signs For International Investors

    "Going global" is a fashionable investing style, but investors should know the risks.
  9. 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.
  10. 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
Hot Definitions
  1. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
  2. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
  3. Income Statement

    A financial statement that measures a company's financial performance over a specific accounting period. Financial performance ...
  4. Leverage Ratio

    A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt, or ...
  5. Annuity

    An annuity is a financial product that pays out a fixed stream of payments to an individual, primarily used as an income ...
  6. Restricted Stock Unit - RSU

    A restricted stock unit is a compensation issued by an employer to an employee in the form of company stock.
Trading Center