Definition of Interest Rate Parity

Interest rate parity is a theory that states that the difference in interest rates of two different countries is the difference of spot and a forward exchange rate of currencies of both the countries. The theory assumes that the gap between the currency exchange rates will eventually be closed with a factor of interest rates in each of the countries. This is why often interest rate parity is used to estimate forward rates.

The mathematical expression for interest rate parity is as follows:

Where IRO =Interest rate in an overseas country

IRD = Interest rate in the domestic country

Assume the current spot rate for 1 USD = Euro 0.75, the interest rate in the US is 3% and in Germany is 4%. The forward rate will be calculated as follows:

Forward rate=0.7500 eu/$ *(1+4%)/(1+3%) =0.7573 eu/$