INTEREST RATE PARITY

Agnes Bofill

INTEREST RATE PARITY

Definition:
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.

WHAT IS THE ROLE OF IRP IN

FOREX TRADING
Interest Rate Parity connects the interest rate, spot exchange rate and foreign exchange rate to
each other.
For example:
Scenario A: 1M CAD is invested at a local risk free rate for 1-year and then enter into a forward
rate agreement to exchange the investment to EUR using a forward exchange rate, at the end
of 3 months.
Scenario B: 1M CAD is converted to EUR using the spot exchange rate, then invest the dollars
for 1-year at a local risk free rate.
Scenario A EUR = Scenario B EUR at the end of 1-year.

ILLUSTRATION

TWO KINDS OF INTEREST RATE

PARITY
Covered Interest Rate Parity
Forward exchange rates should incorporate the difference in interest rates
between two countries.

Uncovered Interest Rate Parity

The difference in interest rates between two countries equals the expected
change in exchange rates between those two countries.

CONCLUSION
Interest Rate Parity is the negates the arbitrage opportunity present in a
market. Furthermore, It also suggests that any arbitrage opportunity
present in the market will be corrected in time.

REFERENCES
www.Investopedia.com
http://www.tutorialspoint.com/international_finance/interest_rate_parity_
model.htm