Interest rate parity (IRP) is a fundamental theory in international finance that describes the relationship between the interest rates of two countries and the exchange rates of their currencies. It states that the difference in interest rates between two countries is offset by the difference between the forward exchange rate and the spot exchange rate, ensuring that investors cannot achieve risk-free arbitrage profits by exploiting interest rate differentials between countries.
In essence, IRP implies that the returns on deposits in different currencies will be equal once adjusted for exchange rate changes, so investors should be indifferent to investing in either currency when exchange rate risk is hedged (covered IRP) or left unhedged (uncovered IRP).
Key Points
The core principle of interest rate parity is that the returns from investing in different currencies, when hedged, should be equal, regardless of their interest rate differences.