Interest rate parity
Also called: IRP · Topic: Balance of Payments and Exchange Rates · NCERT: Beyond NCERT
Meaning
Interest rate parity (IRP) says that the gap in interest rates between two countries equals the expected change in their exchange rate. Because of this, no one can earn a risk-free profit (arbitrage) just by moving money to the country with higher interest rates.
- Covered IRP: the forward premium ≈ the interest differential.
- Uncovered IRP: expected depreciation ≈ the interest differential.
Example
Bonds pay 8% in country A and 10% in country B, a 2% gap. Under uncovered IRP, B's currency is expected to depreciate by about 2% against A's. The extra interest earned in B is then cancelled out by the currency loss.
Don't confuse with
- Purchasing power parity (PPP): PPP links exchange rates to price levels in the long run. IRP links them to interest rates.
Related concepts
- Foreign exchange market
- Foreign exchange
- Foreign exchange rate
- Demand for foreign exchange
- Supply of foreign exchange
- Flexible exchange rate
- Currency depreciation
- Currency appreciation
- Currency speculation
- Interest rate differential