Interest Rate Parity (IRP)

Interest rate parity is a very significant term. Interest rate parity (IRP) is a theory of the relationship between the spot rate and the predicted spot rate or forward rate between two currencies, depending on interest rates. The idea is that the forward exchange rate should be equal to the spot currency exchange rate times the home country’s interest rate, separated by the foreign country’s interest rate. If the relationship of interest rate parity is not valid, you might make a riskless benefit. The scenario that IRP is not in effect will make it easier to adopt an arbitration strategy.

If the real forward exchange rate is higher than the IRP’s forward exchange rate, you might create an arbitrage benefit. To do this, you would borrow currency, swap it at the spot rate, lend at the international interest rate, and lock it in the forward contract. At the forward contract’s maturity, you will swap the money back in your home currency and pay back the money you lent. If the forward price you locked in was better than the IRP balance forward price, so you will have more than the sum you have to pay back. Essentially, you made riskless wealth for nothing but borrowed money.

Interest rate parity is therefore critical in recognizing the determination of the exchange rate. Based on the IRP method, we can see how shifting interest rates can influence what we will assume the spot rate to be later. E.g., by maintaining the foreign country’s interest rate stable and growing its interest rate, we would anticipate the country’s foreign currency to improve. This will affect the projected exchange rate.