Interest Rate Parity

ref: investopedia

Similar to the theory of purchasing power parity (PPP) which is used to compare economic productivity and standards of living between countries, Interest rate parity (IRP) is a theory that governs the relationship between interest rates and currency 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.

Formula of IRP

$F_0 = S_0 * (\frac{1 + i_c}{1 + i_b})$

where:

• $F_0$: Forward rate
• $S_0$: Spot rate
• $i_c$: interest rate in country c (foreign)
• $i_b$: interest rate in country b (domestic)

Terminology

Forward rate

• is an interest rate applicable to a financial transaction that will take place in the future
• In forex, the forward rate specified in an agreement is a contractual obligation that must be honored by the parties involved.
  • For example, consider an American exporter with a large export order pending for Europe, and the exporter undertakes to sell 10 million euros in exchange for dollars at a forward rate of 1.35 euros per U.S. dollar in six-month timeframe.
  • The exporter is obligated to deliver 10 million euros at the specified forward rate on the specified date, regardless of the status of the export order or the exchange rate prevailing in the spot market at that time.

Spot rate

• is the current market value of an asset available for immediate delivery at the moment of the quote. This value is in turn based on how much buyers are willing to pay and how much sellers are willing to accept
• The spot rate reflects real-time market supply and demand for an asset available for immediate delivery

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