Interest Rate Parity

What is Interest Rate Parity?

Interest rate parity becomes applicable whenever we talk about investing in different countries. If an investor gets higher rates in country A than country B, it should be more interested in investing in country A. However, as we invest more in country A, we must buy that country's currency, continually reducing the forward rate spread until no additional profits can be made by making the forward contract-hedged investments.

This relationship is referred to as interest rate parity (IRP), as the discounted spread between domestic and foreign interest rates equals the percentage spread between forwarding and spot exchange rates. In other words, the hedged dollar return on foreign investments should be equal to the return on domestic investments.

Example:

Let's take an example. If we assume that hedged Swiss loans (using forward contracts) offer a higher return than U.S. loans, it makes sense for a bank to focus its activities on making hedged Swiss loans. However, as more is invested in Swiss loans, the bank must buy more Swiss francs. This will continually reduce the forward rate spread until no additional profits can be made by making the forward contract-hedged investments.

As the bank moves into more Swiss loans, the spot exchange rate for buying francs will rise. In equilibrium, the forward exchange rate would have to fall to eliminate the attractiveness of Swiss investments.