Interest Rate Parity (IRP)

What is Interest Rate Parity?

Interest Rate Parity (IRP) is the principle that connects interest rates, spot exchange rates, and forward exchange rates across countries. It states that, after hedging exchange-rate risk, returns on comparable risk-free investments in different currencies should be equal. IRP prevents riskless arbitrage opportunities in the foreign exchange market.

Core idea: the interest-rate differential between two countries is offset by the differential between the forward and spot exchange rates.

Formula

A common way to express covered IRP is:

F = S × (1 + i_domestic) / (1 + i_foreign)

where:
* F = forward exchange rate (price of one unit of foreign currency in domestic currency at future date)
* S = current spot exchange rate (same quote convention as F)
* i_domestic = interest rate in the domestic country
* i_foreign = interest rate in the foreign country

This equality ensures that investing domestically or converting to foreign currency, investing there, and locking in a forward contract to convert back produces the same hedged return.

Forward Rates and Swap Points

• Forward exchange rates are contracts to exchange currencies at a specified rate on a future date. Banks and dealers quote forwards for maturities from days to years.
• Swap points = forward rate − spot rate (often quoted as pips). A positive difference is a forward premium; a negative difference is a forward discount.
• Generally, a currency with a lower interest rate trades at a forward premium relative to a currency with a higher interest rate (and vice versa). That premium/discount offsets the interest differential under IRP.

Covered vs. Uncovered IRP

• Covered Interest Rate Parity (CIRP): Investors use forward contracts to hedge exchange-rate risk. If CIRP holds, there is no arbitrage: the hedged return on a foreign deposit equals the domestic return.
• Uncovered Interest Rate Parity (UIRP): No forward hedge is used; investors rely on expected future spot rates. UIRP asserts that expected changes in the spot rate will offset interest differentials. UIRP is empirical and often fails in practice due to risk premia and imperfect expectations.

How arbitrage enforces IRP (conceptual)

Two equivalent strategies for an investor considering a foreign investment:
1. Convert domestic currency to foreign at the spot rate, invest at the foreign interest rate, and lock in the domestic value of future proceeds with a forward contract.
2. Keep the funds at home and invest at the domestic interest rate.
If the hedged outcomes differ, arbitrageurs will trade until the forward rate adjusts and eliminates the profit opportunity.

Illustrative example (process)

Suppose domestic interest is low relative to a foreign rate. An investor could:
1. Convert domestic currency to foreign at the spot rate.
2. Invest in the foreign risk-free asset for one period.
3. Simultaneously sell the foreign currency forward to lock in the domestic value when proceeds are repatriated.

Under CIRP, the forward rate will be set so that this hedged foreign return equals the domestic risk-free return. If it didn’t, arbitrageurs would execute the above strategy (or its reverse), forcing forward rates to move and restoring parity.

Limitations and real-world deviations

IRP relies on simplifying assumptions; real markets introduce frictions:
* Transaction costs, bid–ask spreads, and capital controls can prevent arbitrage.
* Counterparty credit risk and margin requirements make hedging costly.
* Uncovered IRP depends on investors’ expectations and risk premia; it is frequently violated empirically.
* Market segmentation and limits to arbitrage (e.g., funding constraints) can allow persistent deviations.

Key takeaways

• IRP links interest-rate differentials to forward–spot exchange-rate differentials, ensuring no riskless profit from covered trades.
• Covered IRP uses forward contracts to hedge and is strongly supported in practice, especially in liquid markets.
• Uncovered IRP relies on expected future spot rates and often does not hold due to risk premia and imperfect expectations.
• Deviations can persist because of transaction costs, market frictions, and regulatory constraints.

Further reading

To deepen understanding, review materials on forward contracts, covered interest arbitrage, and empirical studies of uncovered interest rate parity and risk premia.