Interest Rate Parity Guide
Interest rate parity (IRP) is a fundamental forex principle linking exchange rates, interest rates, and forward premiums. It explains why currency forward prices differ from spot prices and underpins the carry trade.
Covered interest rate parity (CIRP) states that the forward exchange rate should offset the interest rate differential between two currencies, preventing arbitrage. If the USD interest rate is 5% and the EUR rate is 3%, the EUR/USD forward rate should trade at a premium (forward points added to spot) to compensate. Arbitrageurs enforce CIRP by borrowing in the low-yielding currency, lending in the high-yielding one, and hedging with forward contracts.
Uncovered interest rate parity (UIRP) holds that the expected change in the spot exchange rate should equal the interest rate differential. If AUD rates are 2% higher than USD rates, UIRP predicts the AUD should depreciate by 2% against the USD over the period. In practice, UIRP fails empirically — high-yielding currencies tend to appreciate rather than depreciate, a phenomenon known as the forward premium puzzle.
Practical Application
Forex traders use CIRP to calculate fair forward points and assess whether swap rates are competitive. UIRP, despite its empirical failures, provides a conceptual framework for understanding how markets incorporate interest rate expectations into spot prices. Forward rates are not predictors of future spot rates but purely a reflection of the interest rate differential.
FAQs
What is the forward premium puzzle?
The empirical observation that currencies with high interest rates tend to appreciate rather than depreciate as UIRP predicts. This puzzle remains one of the unresolved anomalies in international finance.
How do traders use IRP?
Traders use covered IRP to price forwards and evaluate swap points. The failure of uncovered IRP is the basis for carry trade strategies — betting that high-yielding currencies will not depreciate as much as theory suggests.
Do brokers use IRP to set swap rates?
Yes, overnight swap rates are derived from the interest rate differential plus a broker markup, consistent with covered interest rate parity.