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.