Interest Rate Parity (IRP)

Interest rate parity is one of the methods developed to explain exchange rate movements.  Interest rate parity condition states that foreign exchange markets are in equilibrium when expected returns on deposits in a given period in one currency are equal to the expected returns on deposits in another currency when both the returns are measured in terms of a common currency.  There is a simple rule that helps us compare rates of return on different currency deposits. To do that, an investor needs to know two pieces of information: first, the rate of return offered by each currency deposit and second, the expected return due to one currency appreciating against the other currency.

These two components can be combined and formulated as follows:

Here:

R_A = Rate of return on currency a deposits in country A

R_B = Rate of return on currency b deposits in country B

E¹_a/b =Expected exchange rate of a/b one year from now.

E⁰_a/b =a/b spot rate

In summary, as a result of actions of individuals who try to maximize their returns in foreign exchange markets, exchange rates will adjust to satisfy interest rate parity.  This statement is based on the inherit assumption we are making that is individuals in any part of the world prefer to invest in assets paying higher expected returns. It implies that potential holders of foreign deposits view them all as equally desirable assets (in terms of similar risk and liquidity). Therefore, should any arbitrage opportunities arise investors would take advantage driving the difference among expected returns on deposits of different currencies to zero. Spot rates adjust as a result of actions of arbitrageurs in the following way: since everybody would prefer dollar deposits, euro deposit holders would try to sell euro deposits for dollar deposits. Expecting better returns, dollar deposit holders would reject these offers. In response, euro deposit holders would try to tempt dollar deposit holders by offering better price for dollars. This would cause the dollar to appreciate against the euro.