Definition and Example of Interest Rate Parity
The theory of interest rate parity suggests a strong relationship between interest rates and the movement of currency values.
Interest Rate Parity Defined
The underlying concept behind interest rate parity is that it doesn’t matter whether a person invests money in their home country and then converts their earnings to another currency, or converts the money first and invests the money overseas. Because interest rates and forward currency rates are intertwined, the investor makes the same amount of money either way.
To understand interest rate parity, you should become familiar with currency exchange rates. If you’ve ever traveled to another country, you’ve probably exchanged U.S. dollars for a certain amount of another currency. For example, if you are traveling to the United Kingdom, you could exchange $1 for 0.75 British pounds.
In addition to understanding exchange rates, it’s also important to know that interest rates are different in various countries. For example, you may get a 5% return on a Treasury bond in the U.S., while a similar bond in the U.K. might yield 3%.
Interest Rate Parity Example
Suppose Country ABC has an interest rate of 4%, and Country XYZ has a rate of 2%. If an investor in ABC invests in Country XYZ, they will exchange their home currency for XYZ's currency at the current spot rate, investing their cash, earning 2% for the year. However, the investor locks in the forward exchange rate at which the money is to be exchanged back from XYZ's currency to ABC's currency at the end of the year.
On the surface, it might appear that the investor is losing 2% by investing in XYZ when they can earn 4% at home in Country ABC. However, the forward exchange is adjusted to account for the interest rate differential between the two countries. In other words, the forward rate gives the investor back more money than what was initially exchanged to account for the 2% interest rate differential.
How Does Interest Rate Parity Work?
Suppose there is a spot exchange rate of 0.75 British pounds for every U.S. dollar. (£0.75/$1). That means we can exchange $1,000 and receive 750 pounds.
If interest rates in the U.K. are 3%, we can invest 750 pounds at 3% for the year, yielding us $772.50.
Now, suppose that instead of exchanging our currency and investing it in the U.K., we first invest our money in the U.S. and exchange it for British pounds in a year. And let’s say the interest rate in the U.S. is 5%.
In this case, the exchange rate will be the forward exchange rate, which is calculated using the difference in interest rates. The formula is: (0.75 x 1.03) / (1 x 1.05), or (0.7725/1.05). Rounding up, the resulting total is 0.736.
Suppose we start with $1,000 and invest it in the U.S. at 5%. This results in $1,050 at year’s end. We then exchange the $1,050 at the forward exchange rate of 0.736, or $772.80. In other words, we end up with the same amount of money as if we had exchanged our money first and then invested it in the U.K. (Rounding introduces the $0.30 discrepancy.)
With interest rate parity, it doesn't matter whether a person invests money and converts the earnings to another currency first, or converts the money and then invests it. Due to the relationship between interest rates and forward currency rates, the investor ends up making the same amount of money.
Covered vs. Uncovered Interest Parity
When discussing foreign exchange rates, you may often hear about “uncovered” and “covered” interest rate parity. Uncovered interest rate parity exists when there are no contracts relating to the forward interest rate. Instead, parity is simply based on the expected spot rate. With covered interest parity, there is a contract in place locking in the forward interest rate.
In truth, there is often very little difference between uncovered and covered interest rate parity, because the expected spot rate and forward spot rate are usually the same. The difference is that with covered interest parity, you are locking in future rates today. With uncovered interest parity, you are simply forecasting what rates will be in the future.
What Interest Rate Parity Means to Investors
Without interest rate parity, banks could exploit differences in currency rates to make easy money.
Imagine, for example, if you could pay $1.39 for a British pound. Without interest rate parity, an American bank could lock in a one-year forward contract at that rate. Then, it could accept $1 million in deposits and promise a 3% return. Using that $1 million, it could buy 730,000 pounds and invest it in a British bank. If British banks pay a 5% interest rate, the American bank could end up with 766,500 British pounds. Then, it could convert that back to U.S. dollars and end up with a total of $1,065,435, or a profit of $65,435.
The theory of interest rate parity is based on the notion that the returns on an investment are “risk-free.” In other words, in the examples above, investors are guaranteed 3% or 5% returns.
In reality, there is no such thing as a risk-free investment, but when the economies and monetary systems of countries are stable, investors can feel very confident about the returns on treasury bonds. In fact, U.S. Treasury bonds never default, and therefore they are viewed worldwide as risk-free. There are many other highly rated countries, including many in Europe, with bonds that are considered risk-free.
- Interest rate parity is a theory that suggests a strong relationship between interest rates and the movement of currency values.
- The two key exchange rates are the "spot" rate and the "forward" rate. The spot rate is the current exchange rate, and the forward rate is the rate at which a bank agrees to exchange one currency for another in the future.
- Interest rate parity means that it doesn’t matter whether a person invests money in their home country and then converts those earnings to another currency, or converts the money first and invests the money overseas. The investor makes the same amount of money either way.
- Without interest rate parity, banks could exploit differences in currency rates to make easy money.