Interest Rate Party (IRP)

Interest Rate Parity (IRP) is an economic theory that states that the difference in interest rates between two countries should be equal to the difference between the forward exchange rate and the spot exchange rate of their currencies.

In other words, according to IRP, if the interest rate in one country is higher than in another country, then the currency of the country with the higher interest rate will depreciate in the forward exchange rate by an amount that exactly offsets the difference in interest rates. This should result in an equal return on investment between the two currencies, regardless of which currency is used for the investment.

For example, if the interest rate in Country A is 5% and the interest rate in Country B is 3%, according to IRP, the forward exchange rate should reflect a depreciation of the currency of Country A by 2% relative to the currency of Country B, so that investors earn an equal return on investment regardless of which currency they use.

IRP is an important concept in international finance, as it helps explain the relationship between interest rates and exchange rates, and is used to determine the appropriate forward exchange rate for currencies in international trade and investment. However, like all economic theories, IRP has limitations and may not always hold true in the real world, as factors such as capital controls, political risk, and transaction costs can affect exchange rates and investment returns.