what is interest rate parity irp 
interest rate parity irp is a theory that the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate investopedia jessica olahunderstanding interest rate parity irp interest rate parity irp plays an essential role in foreign exchange markets by connecting interest rates spot exchange rates and foreign exchange rates 1it s the fundamental equation that governs the relationship between interest rates and currency exchange rates the basic premise of irp is that hedged returns from investing in different currencies should be the same regardless of their interest rates irp is the concept of no arbitrage in the foreign exchange markets the simultaneous purchase and sale of an asset to profit from a difference in the price investors can t lock in the current exchange rate in one currency for a lower price and then purchase another currency from a country offering a higher interest rate the formula for irp is f0 s0 1 ic1 ib where f0 forward rates0 spot rateic interest rate in country cib interest rate in country b begin aligned f 0 s 0 times left frac 1 i c 1 i b right textbf where f 0 text forward rate s 0 text spot rate i c text interest rate in country c i b text interest rate in country b end aligned f0 s0 1 ib 1 ic where f0 forward rates0 spot rateic interest rate in country cib interest rate in country b forward exchange ratean understanding of forward rates is fundamental to irp especially as it pertains to arbitrage forward exchange rates for currencies are exchange rates at a future point in time unlike spot exchange rates which are current rates 2forward rates are available from banks and currency dealers for periods ranging from less than a week to five years and more forwards are quoted with a bid ask spread as are spot currency quotations the difference between the forward rate and the spot rate is known as swap points it s known as a forward premium if the forward rate minus the spot rate is positive a negative difference is a forward discount a currency with lower interest rates will trade at a forward premium in relation to a currency with a higher interest rate the u s dollar typically trades at a forward premium against the canadian dollar conversely the canadian dollar trades at a forward discount versus the u s dollar covered vs uncovered interest rate paritythe irp is said to be covered when the no arbitrage condition can be satisfied through the use of forward contracts in an attempt to hedge against foreign exchange risk 3the irp is uncovered when the no arbitrage condition could be satisfied without the use of forward contracts to hedge against foreign exchange risk 4the relationship is reflected in the two methods an investor can adopt to convert foreign currency into u s dollars the first option an investor can choose is to invest the foreign currency locally at the foreign risk free rate for a specific period the investor would then simultaneously enter into a forward rate agreement to convert the proceeds from the investment into u s dollars using a forward exchange rate at the end of the investing period the second option would be to convert the foreign currency to u s dollars at the spot exchange rate and then invest the dollars for the same amount of time as in option a at the local u s risk free rate the cash flows from both options are equal when no arbitrage opportunities exist arbitrage is defined as the simultaneous purchase and sale of the same asset in different markets to profit from tiny differences in the asset s listed price arbitrage trading in the foreign exchange world involves the buying and selling of different currency pairs to exploit any pricing inefficiencies 