Interest Rate Parity

The relationship that sets forward exchange rates so that differences in interest rates between two currencies are offset.

Example

Forward = Spot x (1 + quote rate) / (1 + base rate): 1.1000 x 1.05 / 1.03 = 1.1214.

Important

It explains why a currency with higher interest rates trades at a lower forward price relative to one with lower rates.

Related terms

• Forward Rate — An exchange rate agreed today for a currency exchange that will happen on a future date.
• Carry Trade — Borrowing or selling a low-interest currency to hold a higher-interest one, aiming to earn the rate difference.

Lessons that explain it

• No earnings, no dividends - just relative rates, inflation and flows — A currency has no cash flow to value. Its price reflects interest rates, inflation, trade and capital flows and sentiment, and forward prices are set mechanically by interest rate differences. (11 min)

All 578 terms in the Investing glossary