Interest Rate Parity
AdvancedInterest rate parity is the principle that the difference in interest rates between two countries should be offset by the difference between the forward exchange rate and the spot exchange rate, so that investors cannot earn risk-free profits by moving money between currencies.
If one currency offers higher interest rates than another, investors might be tempted to move money into it. Interest rate parity says that, when currency risk is hedged with a forward contract, the extra interest is cancelled out by a less favourable forward rate.
For example, suppose one euro buys 1.10 US dollars today, US interest rates are 5% and euro interest rates are 3% for one year. Covered interest rate parity implies a one-year forward rate of about 1.1214 dollars per euro. An investor who converts dollars into euros, earns 3% and converts back at the forward rate ends up with the same amount as one who simply earns 5% in dollars.
This version, covered interest rate parity, generally holds closely in normal markets because of arbitrage, although small deviations have appeared since 2008. Uncovered interest rate parity, which assumes expected future exchange rates offset interest differences without hedging, often fails in practice, which is why carry trades, borrowing in low-rate currencies to invest in high-rate ones, can be profitable for long periods, but also risky.
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