Interest Rates Parity Theory (IRP) is associated with the difference in interest rates between two countries. It is equal to the difference between the spot exchange rate and the forward exchange rate.

In the foreign exchange market, IRP plays an important role. It is connected to foreign exchange rates, spot exchange rates, and interest rates.

This fundamental equation (IRP) governs the relationship between the currency exchange rates and the interest rates. The rule (the basic premise) is that, apart from their interest rates, the hedged returns on investments in different currencies must be the same.

Calculating the Interest Rates Parity Theory

In the foreign exchange market, the IRP is a no-arbitrage concept (simultaneous selling and buying to profit from price differences). The current exchange rate in one currency cannot be locked by an investor for a lower price then buy another currency with higher interest rate.

The formula is:

F0=S0+((1+ic)/(1+ib))

Where:

F0 is the forward rate

S0 is the spot rate

Ic is the interest rate in country A

Ib is the interest rate in country A

The forward exchange rate for a currency is an exchange rate in future time at a point. It is opposed to the spot rate which is the current exchange rate.

This understanding is very essential especially about arbitration. Forward rates are available from currency dealers and banks for a period ranging from less than a week to 5 years and more.

Forwards are like spot currency quotations; they are quotes with a bid-ask spread. The swap point is the difference between spot rate and forward rate.

The forward premium is if the forward rate minus the spot rate (the difference) is positive. If it is negative, then the term is a forward discount.

Currencies with lower interest rates will be traded at a forward premium related to the currency with a higher level of interest rate. For instance, the U.S. dollar against the Canadian dollar is typically traded at a forward premium.

Kind of Interest Rates Parity Theory

When a non-arbitration condition can be met through the use of a forward contract, an IRP is said to be covered. This is in an attempt to hedge against the risk of foreign exchange.

In contrast, when a non-arbitrage condition can be met to hedge against foreign exchange risk without using a forward contract, the IRP is uncovered. The two methods reflect the relationship.

Investors can convert foreign currencies into U.S. dollars. One option that can be taken is to locally invest the foreign currency for a specific period at a foreign risk-free.

The proceeds then can be converted to U.S dollar from the investments once the investors enter a forward agreement. At the end of the investment period, they can use a forward exchange rate.

The second option is the spot exchange rate to convert the foreign currency to U.S. dollars. Then the dollar can be invested for the same amount. 

When there is no arbitrage opportunity, there is the same cash flow of both options. Based on the assumptions that come with it, the Interest Rates Parity Theory has been criticized.

For example, according to the covered IRP model, there are unlimited funds for currency arbitrage. This is unrealistic.

When a forward or futures contract is not available for hedging, an uncovered IRP is likely to be valid in the real world. This is an essential thing traders need to understand in forex trading.

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