Interest Rate Parity

Interest Rate Parity is a financial theory that explains how different interest rates on currencies affect their exchange rates. It states that if one country’s interest rates are higher than another's, its currency will depreciate in the future to balance the return on investments. Essentially, it ensures that investors earn the same returns on comparable investments in different currencies, after accounting for exchange rates. If this balance didn’t exist, it would create arbitrage opportunities, leading traders to exploit differences until they equalize. This principle helps maintain equilibrium in the foreign exchange market.