interest-rate parity
/ IRP /
Imagine you have money to park for a year and two choices: a savings account at home paying 2 percent, or one abroad paying 6 percent. The foreign one looks like free money — four extra percentage points. But to use it you must first convert your money into the foreign currency and convert it back at the end, and the exchange rate might move against you in between. Interest-rate parity is the principle that, once you account for expected exchange-rate moves, those two options should give you roughly the same return. If they did not, traders would pile into the better deal until the gap closed.
The intuition is that a currency paying high interest is usually one the market expects to weaken, and that expected weakening cancels out the interest advantage. In our example, if foreign rates are 4 points higher, the market will tend to expect the foreign currency to lose about 4 percent against yours over the year — so your extra interest is roughly eaten up by the currency falling when you convert back. Economists split this into two flavours: covered interest parity, where you lock in the future exchange rate today with a forward contract (this version holds very tightly because any gap is pure risk-free arbitrage), and uncovered interest parity, where you simply hope your guess about the future rate is right (this version is far shakier).
Interest-rate parity is one of the deep links between a country's interest rates and its exchange rate, and it explains why raising rates often makes a currency jump: higher rates draw in money chasing yield, lifting demand for the currency. But the honest caveat is large. Covered parity holds almost perfectly because it is enforceable arbitrage, yet uncovered parity — the version that would let you predict currencies from interest gaps — fails badly in the real world. High-interest currencies have historically often not depreciated as the theory says, a stubborn puzzle that funds the risky 'carry trade.' So treat interest-rate parity as a clean idea about where pressure points, not a money-making forecast.
Investors borrowed cheaply in low-interest yen for years to buy higher-yielding Australian dollars — the 'carry trade' — pocketing the interest gap that uncovered interest parity says should not exist; it worked until the yen suddenly strengthened and the trade unwound in painful losses.
In theory the interest gap should vanish; in practice the carry trade lives off it.
Covered interest parity (with the future rate locked in) holds almost perfectly, but uncovered parity — the version needed to forecast currencies from interest gaps — empirically fails, which is exactly why the carry trade can be profitable yet risky.