Macro & Central BanksCovered Interest ParityIRP
Interest Rate Parity
The no-arbitrage relationship linking spot and forward exchange rates to the interest rate differential between two currencies.
What Interest Rate Parity means
Interest rate parity comes in two forms. Covered interest parity is an arbitrage condition: an investor who converts at the spot rate, deposits in the foreign currency and locks in a forward contract to convert back must end up with the same amount as one who simply deposits at home. This forces the forward premium or discount to equal the interest rate differential. If it did not, a riskless profit would exist, so covered parity generally holds tightly, with deviations reflecting funding frictions and balance sheet costs rather than free money.
Uncovered interest parity drops the forward hedge and asserts that a high-yielding currency should be expected to depreciate by enough to cancel its yield advantage. Empirically this fails over short and medium horizons, and that failure is precisely what makes the carry trade profitable in calm conditions. In practice covered parity is what determines swap and rollover charges on a leveraged position: holding the high-yield side earns roughly the differential, minus whatever markup the counterparty applies.
Worked example
If one-year rates are 5 percent in the United States and 1 percent in Japan with spot at 152.40, covered parity puts the one-year forward near 146.60, so the yen trades at a forward premium that offsets its lower yield. Illustrative figures.
Related terms
- Purchasing Power Parity (PPP)The theory that exchange rates should adjust so that a basket of goods costs the same across countries once converted into a common currency.
- Forward ContractAn agreement to exchange currencies at a fixed rate on a future date beyond the standard spot settlement window.
- Carry TradeA strategy of holding a higher-yielding currency against a lower-yielding one to earn the interest differential.
- SwapThe interest credited or debited for holding a forex position overnight, based on the two currencies' rate differential.
- Bond YieldThe annual return an investor earns on a bond given its price, which moves inversely to the bond's price.
Frequently asked questions
What does Interest Rate Parity mean in forex trading?
The no-arbitrage relationship linking spot and forward exchange rates to the interest rate differential between two currencies.
How does Interest Rate Parity work in practice?
Uncovered interest parity drops the forward hedge and asserts that a high-yielding currency should be expected to depreciate by enough to cancel its yield advantage. Empirically this fails over short and medium horizons, and that failure is precisely what makes the carry trade profitable in calm conditions. In practice covered parity is what determines swap and rollover charges on a leveraged position: holding the high-yield side earns roughly the differential, minus whatever markup the counterparty applies.
What is an example of Interest Rate Parity?
If one-year rates are 5 percent in the United States and 1 percent in Japan with spot at 152.40, covered parity puts the one-year forward near 146.60, so the yen trades at a forward premium that offsets its lower yield. Illustrative figures.
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