We are independent & ad-supported. We may earn a commission for purchases made through our links.
Advertiser Disclosure
Our website is an independent, advertising-supported platform. We provide our content free of charge to our readers, and to keep it that way, we rely on revenue generated through advertisements and affiliate partnerships. This means that when you click on certain links on our site and make a purchase, we may earn a commission. Learn more.
How We Make Money
We sustain our operations through affiliate commissions and advertising. If you click on an affiliate link and make a purchase, we may receive a commission from the merchant at no additional cost to you. We also display advertisements on our website, which help generate revenue to support our work and keep our content free for readers. Our editorial team operates independently of our advertising and affiliate partnerships to ensure that our content remains unbiased and focused on providing you with the best information and recommendations based on thorough research and honest evaluations. To remain transparent, we’ve provided a list of our current affiliate partners here.

What is Interest Rate Parity?

John Lister
By
Updated May 17, 2024
Our promise to you
WiseGeek is dedicated to creating trustworthy, high-quality content that always prioritizes transparency, integrity, and inclusivity above all else. Our ensure that our content creation and review process includes rigorous fact-checking, evidence-based, and continual updates to ensure accuracy and reliability.

Our Promise to you

Founded in 2002, our company has been a trusted resource for readers seeking informative and engaging content. Our dedication to quality remains unwavering—and will never change. We follow a strict editorial policy, ensuring that our content is authored by highly qualified professionals and edited by subject matter experts. This guarantees that everything we publish is objective, accurate, and trustworthy.

Over the years, we've refined our approach to cover a wide range of topics, providing readers with reliable and practical advice to enhance their knowledge and skills. That's why millions of readers turn to us each year. Join us in celebrating the joy of learning, guided by standards you can trust.

Editorial Standards

At WiseGeek, we are committed to creating content that you can trust. Our editorial process is designed to ensure that every piece of content we publish is accurate, reliable, and informative.

Our team of experienced writers and editors follows a strict set of guidelines to ensure the highest quality content. We conduct thorough research, fact-check all information, and rely on credible sources to back up our claims. Our content is reviewed by subject-matter experts to ensure accuracy and clarity.

We believe in transparency and maintain editorial independence from our advertisers. Our team does not receive direct compensation from advertisers, allowing us to create unbiased content that prioritizes your interests.

Interest rate parity is an economic theory involving interest rates in two countries and the exchange rate between their currencies. The theory says that the difference in the exchange rates will be proportionally the same as the difference between the exchange rate now and the exchange rate for deals that are agreed now but completed later. If the theory is correct, this means there may be an opportunity to make money when these proportions differ. Some economic theories dispute that this parity exists.

There are three key variables in the theory of interest rate parity. One is the risk-free interest rate in each country. As a risk-free rate is hypothetical, the calculations can work with either the central bank's lending rate, or the rates being offered on government bonds. Both of these should be close enough to a guaranteed interest payment at a guaranteed rate for the purposes of the theory.

The second variable is the spot exchange rate. This is the current market exchange rate between the currencies of the two countries. The third variable is the future rate. This is the prevailing market rate for currency futures contracts, on which two investors agree to a currency exchange on a future date at a fixed price. This rate will vary depending on how the two investors forecast the spot rate will change over time.

The theory of interest rate parity is that the proportional difference between the interest rates will equal the proportional difference between the spot rate and the future rate. In most cases, the calculation will be based on the interest rates for the next 12 months and the future rate for exchanges that will be completed in 12 months. If the theory is correct, though, the parity holds true for any period: the interest rate simply needs to be adjusted to cover the time. For example, if the future rate is for six months from now, the calculation is performed by halving each country's annual interest rate.

While there are complex explanations for how interest rate parity works, the general principle is that investor behavior will ensure it exists. This is because normally, if interest rate parity does exist, an investor will get the same return from two different strategies: investing in country A now while setting up a forward rate agreement to convert the money into country B's currency after a certain period, or converting to currency B now and investing for the same period in country B. If there is a disparity between the returns from these options, the investor will naturally choose the one with the better return. The theory is that enough people will do this that it will distort either the spot or future exchange rates until interest rate parity is restored.

WiseGeek is dedicated to providing accurate and trustworthy information. We carefully select reputable sources and employ a rigorous fact-checking process to maintain the highest standards. To learn more about our commitment to accuracy, read our editorial process.
John Lister
By John Lister
John Lister, an experienced freelance writer, excels in crafting compelling copy, web content, articles, and more. With a relevant degree, John brings a keen eye for detail, a strong understanding of content strategy, and an ability to adapt to different writing styles and formats to ensure that his work meets the highest standards.
Discussion Comments
John Lister
John Lister
John Lister, an experienced freelance writer, excels in crafting compelling copy, web content, articles, and more. With...
Learn more
WiseGeek, in your inbox

Our latest articles, guides, and more, delivered daily.

WiseGeek, in your inbox

Our latest articles, guides, and more, delivered daily.