What is Interest Rate Parity?

Interest rate parity is a financial theory that connects forward exchange rates, spot exchange rates, and nations' individual interest rates. It is the theory with which foreign exchange investors can calculate the value of their money in other countries.

Forward Exchange Rate

Forward exchange rates are futures contracts in which a trader agrees to buy a currency (which, after all, is traded on markets just like everything else) at a specific price at a specific point in the future.

Spot Exchange Rate

A spot exchange rate is what the trader can get for his currency right now. Airport kiosks, for example, with their digital signs that say exchange rates, are advertising a spot exchange rate.


Interest Rate Parity

When interest rate parity exists, there are no options for profit, as the difference between the spot exchange rate and the foreign exchange rate are equivalent to the differences in two countries' interest rates. So, investing money in a local bank account while simultaneously signing a forward exchange agreement will yield the same amount of money as would buying currency at a spot rate and investing it in a foreign bank account.