Interest Rate Parity Theory

Interest Rate Parity (IRP) is a financial theory that explains the relationship between interest rates and exchange rates between two countries. It suggests that the difference in interest rates reflects the expected change in the exchange rate over time. For example, if one country has higher interest rates, its currency is expected to depreciate relative to another country's currency, balancing out gains from higher interest. This ensures that investors cannot make risk-free profits from interest rate differentials by exchanging currencies and investing abroad, maintaining equilibrium between spot (immediate) and forward (future) exchange rates.