Interest rate parity is an economic term describing the relationship among spot currency exchange rates, forward currency exchange rates and interest rates. It is used in international banking to determine the rate at which to buy or sell currencies.
- The spot rate is the rate at which currency is exchanged today. The forward rate is the rate established today that applies to a currency trade that will occur in the future.
- Investors can earn interest by lending currency. Interest rate parity suggests that the rate at which currency A can be exchanged for currency B is related to the interest rates that can be earned in countries A and B.
- To prevent arbitrage opportunities from arising, the ratio of the forward exchange rate to the spot exchange rate must equal the ratio of the currency returns for the two countries.
- (Forward rate / spot rate) = (1 + interest rate A) / (1 + interest rate B)
Exchange rates are expressed as the quantity of A required to purchase one B. - Interest rate parity assumes that there will be no transaction fees and that neither party will default on the transaction. In actual practice, currency prices quoted by banks to customers often include a risk premium.
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