Interest Rate Parity

Business, Legal & Accounting Glossary

Definition: Interest Rate Parity


Quick Summary of Interest Rate Parity


An arbitrage condition that must hold between the spot interest rates of different currencies.




Full Definition of Interest Rate Parity


Interest rate parity is a relationship that must hold between the spot interest rates of two currencies if there are to be no arbitrage opportunities.

The relationship depends upon spot and forward exchange rates between the currencies.

It is:

Interest Parity Rate Equation[1]

where

  • s is the spot exchange rate, expressed as the price in currency a of a unit of currency b;
  • f is the corresponding forward exchange rate;
  • ra and rb are the interest rates for the respective currencies; and
  • m is the common maturity in years for the forward rate and the two interest rates.

In formula [1], the interest rates are assumed to be annually compounded commercial rates, such as Libor rates. If they are continuously compounded, formula [1] becomes:

Interest Parity Rate Example[2]

where and are continuously compounded rates, and e is the natural log base (2.718281828…).

Interest rate parity plays a fundamental role in foreign exchange markets, enforcing an essential link between short-term interest rates, spot exchange rates, and forward exchange rates.


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Definition Sources


Definitions for Interest Rate Parity are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 4th August, 2021 | 3 Views.