What is Interest Rate Parity?
Interest rate parity connects the interest rates, spot exchange rates and forward exchange rates in a single comparison. The theory is that the differential between the interest rates of two countries is the same as the difference between the forward exchange rate and the spot exchange rate. As a result, the theory maintains there is no difference between investing locally in a foreign market or exchanging currency to invest in the foreign market directly.
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Spot Exchange Rate
The spot exchange rate is simply the foreign exchange rate at the current moment. Even though it typically takes one to two days to fully settle a currency conversion, the spot rate is listed on a daily basis and closed that day. So, with the spot exchange rate, an investor is looking to place money into a foreign currency, the investor would simply pay the rate to change the currency today. Then, the investor would hold the currency or invest it in the foreign market.
Forward Exchange Rate
The forward exchange rate is a currency rate in the future, but the price of the exchange is set today. It is similar to a futures contract on a currency conversion. The investor sets the price for the conversion that will take place in the future, typically a few weeks to a few months down the line, today. In this model, the investor would invest locally but enter an agreement to have all proceeds from the investment converted to another currency at a rate set today.
Interest Rate Parity
The theory of interest rate parity essentially states that, whichever model the investor chooses, the ultimate result will be the same. Even though there is no certain profit from the investment scheme, the model holds that each scheme will have the same profit as the other. Therefore, it is not necessary to choose between the options based on potential profit. Instead, an investor can choose based on personal preference.
Covered Interest Rate Parity
Covered interest rate parity simply means you are making the transaction knowing the exchange rate between two currencies. You have "covered" your risks. Whether you exchange at the spot rate today or set a forward rate for 30 days from now, you are "covering" the risk of the interest rate fluctuating. You know exactly what the exchange rate will be when you ultimately change from one currency to the next.
Uncovered Interest Rate Parity
Uncovered interest rate parity means you are unsure of the exchange rate that will ultimately be used in your conversion. You do not use the spot rate today to transfer money into the other currency. Instead, you invest locally, and you await your profits to convert them to another currency. However, you have not set the exchange rate using a forward model. Instead, you will be accepting the rate, whatever it may be, on the day you decide to convert. You have not "covered" the risk of a drastic change in exchange rates. Therefore, even if your profits are high, you may end up losing money on the exchange.
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