Interest rate parity (IRP) is a theory according to 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 (IRP) plays an essential role in foreign exchange markets by connecting interest rates, spot exchange rates, and foreign exchange rates.
IRP is the fundamental equation that governs the relationship between interest rates and currency exchange rates. The basic premise of IRP is that hedged returns from investing in different currencies should be the same, regardless of their interest rates.
The forward exchange rate should equal the spot currency exchange rate multiplied by the interest rate of the home country, then divided by the foreign currency interest rate.
Interest rate parity is also behind the no-arbitrage concept. In foreign exchange markets, this refers to the purchase and sale of a single asset enabling a trader to benefit from price differences. In other words, a forex trader can’t lock in the currency exchange rate from one country at a lower price, simultaneously purchasing another currency with a higher interest rate.
IRP is the concept of no-arbitrage in the foreign exchange markets (the simultaneous purchase and sale of an asset to profit from a difference in the price). 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.
The formula for IRP is:
F0 = S0 * {{1+ ic) / (1+ 1b)}
where:
F0 =Forward Rate
S0 =Spot Rate
ic =Interest rate in country c
ib = Interest rate in country b
Interest rate parity is an important concept. If the interest rate parity relationship does not hold true, then you could make a riskless profit. The situation where IRP does not hold would allow for the use of an arbitrage strategy. For example, let us look at the scenario where the forward exchange rate is not in equilibrium with the spot exchange rate.
If the actual forward exchange rate is higher than the IRP forward exchange rate, then you could make an arbitrage profit. To do this, you would borrow money, exchange it at the spot rate, invest at the foreign interest rate and lock in the forward contract. At maturity of the forward contract, you would exchange the money back into your home currency and pay back the money you borrowed. If the forward price you locked in was higher than the IRP equilibrium forward price, then you would have more than the amount you must pay back. You have essentially made riskless money with nothing but borrowed funds.
Interest rate parity is also important in understanding exchange rate determination. Based on the IRP equation, we can see how changing the interest rate can affect what we would expect the spot rate to be at a later date. For example, by holding the foreign country interest rate steady and increasing the home country’s interest rate, we would expect the home country currency to appreciate in relation to the foreign currency. This would affect the expected exchange rate.
Covered vs. Uncovered interest rate parity
When the no-arbitrage condition mentioned above is satisfied using forward contracts, the IRP is ‘covered.’ If the no-arbitrage condition can still be met without using forward contracts to hedge against risk, this is called uncovered interest rate parity.
Uncovered and covered interest rate parity look similar, the only difference being the use of forward contracts. For example, imagine that a British investor is converting AUD into GBP. The investor agrees to invest the foreign currency (AUD in this case) locally at a risk-free foreign rate. He enters a forward rate agreement, which states he will convert any proceeds at the end of the investing period into GBP at the forward exchange rate. This would be a covered interest rate parity example concept.
By contrast, he could also choose to convert the AUD into GBP using the spot exchange rate, then investing this GBP for the same period at the local risk-free rate. This technique would be using uncovered interest rate parity, and both should end up with equal cash flows.