What Is Interest Rate Parity (IRP)?
The interest rate parity theory helps describe the relationship between foreign exchange rates and interest rates. According to the interest rate parity theory (IRP), the difference in national interest rates for financial securities and derivatives of similar risk and maturities should be equal to the forward rate discount or premium for the foreign currency.
This means that when an investor chooses whether to invest in the domestic market or a foreign market, the returns would be approximately equal, given that the risks and maturities of the securities are similar.
This means that differences in national interest rates help set the forward rates at which financial securities are set.
Understanding 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.
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 cannot 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: