Interest rate parity is a theory that suggests a strong relationship between interest rates and the movement of currency values. In fact, you can predict what a future exchange rate will be simply by looking at the difference in interest rates in two countries.
It’s not always easy to grasp why the value of currencies can change. Learn how currency rates and interest rates are intertwined.
What Is Interest Rate Parity?
The theory of interest rate parity suggests a strong relationship between interest rates and the movement of currency values.
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 those 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.
The two key exchange rates in interest rate parity are the “spot” rate and the “forward” rate. The spot rate is the current exchange rate, while the forward rate refers to the rate that a bank agrees to exchange one currency for another in the future.
To understand interest rate parity, you should get familiar with the notion of 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 be able to get a 5% return on a treasury bond in the U.S., while a similar bond in the U.K. might yield 3%.
How Does Interest Rate Parity Work?
Let’s say there is a spot exchange rate of 0.75 British pounds for every U.S. dollar. (£0.75/$1). This 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, let’s say 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. In this case, 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.
Now, let’s say 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 .736, or about $772.50. 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.
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.
Why Interest Rate Parity Matters
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, ending 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 free of risk.
- 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 that a bank agrees to exchange one currency for another in the future.
- Interest rate parity means 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.