With all the hype of interest rates going around, it is probably time for me to write about one little known relationship between interest rates of different countries and the currency exchange between the said countries. Introducing the concept of interest rate parity.
What Is Interest Rate Parity?
According to Investopedia, interest rate parity is “a theory according to which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate”1.
Putting it simply, assuming a scenario of two countries (Country A and Country B) with interest rates of 5% in Country A and 3% in Country B, the currency exchange rate between the two will adjust by 2% in the future (either Country A’s currency would depreciate by 2% or Country B’s currency would appreciate by 2%).
Investors would go for “more bang for the buck”, so if a country’s interest rates are higher, they would naturally flock there with their capital to earn more. Eventually, all things would equalize out in the form of currency exchange rates. These happenings are, of course, theoretical, and certain conditions must be assumed, e.g., free flow of capital exists between the two countries. In the real world, things may not be that simple with all the microeconomic, macroeconomic and regulatory factors and circumstances at play.
Real World Applications
There are a few real-world scenarios where the theory of interest rate parity is applicable. A financial instrument called currency swap is one example, where the capital principal and/or interest rate could be exchanged with another currency, to obtain favourable loan interest rates. Currency swaps are also used to hedge against foreign exchange fluctuations, which a lot of multinational companies and real estate investment trusts utilise.
Forex traders also use the theory of interest rate parity to implement strategies and calculations to earn profits.
1 – Hayes, Adam. Interest Rate Parity (IRP). Investopedia. 5 Sep 2021. https://www.investopedia.com/terms/i/interestrateparity.asp (accessed 21 Aug 2022)