Using the exponential formula ensures compounding accuracy for periods greater than 1 year, though the linear approximation is often used for short-term money market instruments.
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Interest Rate Parity (IRP) is a theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.
Put simply: You cannot make a profit merely by borrowing money in a low-interest country and investing it in a high-interest country IF you hedge your currency risk.
The market adjusts the Forward Exchange Rate to exactly offset the interest rate advantage, ensuring that the return on investment is the same regardless of which currency you hold.
How the Formula Works
The core formula linking the Spot Rate (S) and Forward Rate (F) is:
If the domestic interest rate is higher than the foreign one, the fraction (1 + r_d) / (1 + r_f) is greater than 1. This means the Forward Rate will be higher than the Spot Rate? Wait, let's re-examine convention.
Usually, we quote Price/Base. If Domestic Rate is higher, the Domestic currency is expected to depreciate to offset the yield. If the quote is Domestic/Foreign (e.g. USD/EUR where USD is domestic), and USD rates are higher, the Forward price of EUR (in USD) will be higher (Premium).
Why? To prevent you from converting EUR to USD, earning 5%, and converting back. The future USD must be worth less (requires more USD to buy 1 EUR) to wipe out that 5% gain.
Covered vs. Uncovered IRP
Covered IRP (CIP)
You use a forward contract to lock in the exchange rate today.
This holds true almost 100% of the time because arbitrageurs (banks/algos) instantly exploit any deviation. It is risk-free arbitrage.
Uncovered IRP (UIP)
You do not hedge. You assume the future spot rate will naturally move to the theoretical level.
This often fails in reality. High-interest currencies often appreciate instead of depreciate short-term (the "Carry Trade").
Why Higher Interest Rates Mean "Discount"
This is often counter-intuitive. We often hear "Rate hikes strengthen the currency." That is true for the Spot rate (everyone buys the currency today to get the yield).
However, in the Forward market, that same high-rate currency trades at a Discount. This is mathematical necessity.
If Currency A pays 10% and Currency B pays 0%.
If the exchange rate stayed flat, everyone would just hold A.
To balance this, the market prices Currency A to lose ~10% of its value against B over the year in the forward contract.
Arbitrage and Real-World Risks
While Covered Interest Parity is a solid rule, it broke down slightly during the 2008 crisis and 2020 pandemic. This deviation is known as the Cross-Currency Basis.
It happens because of:
Dollar Shortages: Global banks desperate for USD will "overpay" in the swap market, violating IRP.
Regulation: Balance sheet constraints (Basel III) prevent banks from arbitraging small discrepancies.
Counterparty Risk: The fear that the other bank won't be there to pay you in 1 year.
Frequently Asked Questions
Expert answers to common questions about Interest Rate Parity
Does Interest Rate Parity always hold?
Covered IRP holds very tightly in major currencies (USD, EUR, JPY) due to efficient arbitrage. Uncovered IRP rarely holds in the short to medium term, which is why the "Carry Trade" strategy exists.
What is a Forward Premium vs. Discount?
A currency is at a Premium if the forward rate is higher than the spot rate (it's more expensive in the future). It is at a Discount if the forward rate is lower (cheaper in the future).
Which currency trades at a discount?
The currency with the higher interest rate always trades at a forward discount against the currency with the lower rate. This discount offsets the interest gain.
How does this help importers/exporters?
It helps them determine the "cost of hedging." If an importer needs to buy a high-interest currency in the future, IRP tells them they can lock in a cheaper rate today (forward discount) than the current spot price.
What is the "Carry Trade"?
Carry Trade involves borrowing a low-interest currency (like JPY) and buying a high-interest currency (like AUD) without hedging. If the exchange rate doesn't change, the trader profits from the interest difference. This bets against Uncovered IRP.
Why does the formula use (1+r)?
The (1+r) represents the principal plus interest at the end of the period. The ratio compares what 1 unit of money grows to in Domestic vs. Foreign markets.
What is the role of inflation?
Inflation drives interest rates (Fisher Effect), which in turn drives forward rates (IRP). High inflation usually leads to high nominal interest rates, which leads to a forward discount (depreciation expectation).
Can I use this for crypto?
Yes, Perpetual Futures funding rates in crypto are essentially an IRP mechanism. If longs pay shorts fees, the futures price trades above spot (Contango), reflecting the "interest rate" of borrowing leverage.
What happens if IRP is violated?
If the forward rate deviates significantly from IRP, arbitrageurs will borrow in the cheap currency, convert it, invest in the expensive one, and lock in the profit with a forward contract until the prices align.
Does IRP apply to pegged currencies?
For pegged currencies (like HKD to USD), IRP keeps interest rates very close. If rates diverged, massive capital flows would force the central bank to intervene or unpeg.
Summary
The Interest Rate Parity Calculator computes the "No-Arbitrage" forward exchange rate.
It demonstrates that exchange rate expectations are mathematically linked to interest rate differentials.
Use this tool to calculate hedging costs and understand the theoretical equilibrium of Forex markets.
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Compute theoretical forward FX rates from spot and interest rates based on interest rate parity.
How to use Interest Rate Parity Calculator
Step-by-step guide to using the Interest Rate Parity Calculator:
Enter your values. Input the required values in the calculator form
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Frequently asked questions
How do I use the Interest Rate Parity Calculator?
Simply enter your values in the input fields and the calculator will automatically compute the results. The Interest Rate Parity Calculator is designed to be user-friendly and provide instant calculations.
Is the Interest Rate Parity Calculator free to use?
Yes, the Interest Rate Parity Calculator is completely free to use. No registration or payment is required.
Can I use this calculator on mobile devices?
Yes, the Interest Rate Parity Calculator is fully responsive and works perfectly on mobile phones, tablets, and desktop computers.
Are the results from Interest Rate Parity Calculator accurate?
Yes, our calculators use standard formulas and are regularly tested for accuracy. However, results should be used for informational purposes and not as a substitute for professional advice.