Welcome to the Investors Trading Academy talking
glossary of financial terms and events. Our word of the day 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.
The relationship can be seen when you follow the two methods an investor may take to convert
foreign currency into U.S. dollars. Option A 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. Option B 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 risk-free rate. When no arbitrage opportunities exist,
the cash flows from both options are equal.