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Interest rate parity is one of the major applications of the Law of One Price and plays a major role in forex trading markets. It links the short-term interest rates, spot exchange rates and forward exchange rates of two or more different currencies. It is a non arbitrage condition according to which the returns obtained from borrowing in a particular currency, exchanging that currency for another and investing in interest-carrying instruments in the second currency, and at the same time buying futures contracts to convert the currency back by the end of the investment period, will be equal to the returns one gets by buying and holding similar interest bearing instruments of the first currency. Whenever the theory is violated, an arbitrage opportunity is created.

There are two versions of interest rate parity known as covered interest rate parity and uncovered interest rate parity.

Covered Interest Rate Parity is also known as Interest Parity Condition. It assumes that the ‘interest rate return from different currencies will be the same if one covers against currency changes.’ That is, the returns will be the same when you invest USD in US deposits and the same dollar amount in a foreign currency, and protect that investment using a forward on the foreign currency.

Uncovered Interest Rate Parity is a condition that assumes that ‘the difference between the interest rate of two currencies will be equal to the expected depreciation of a currency.’ That is, a 10% depreciation of the USD against any foreign currency is to be compensated by a 10% rise in the interest rate of the dollar.

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