1. What is Interest Rate Parity?

Interest Rate Parity (IRP) is a theory that suggests the relationship between interest rates and exchange rates of two countries is balanced. The forward exchange rate should equal the spot exchange rate times the ratio of the two countries' interest rates.

2. How Does the Calculator Work?

The calculator uses the Interest Rate Parity formula:

Where:

• \( Spot\ Rate \) — Current exchange rate between two currencies
• \( Domestic\ Interest \) — Interest rate in the domestic country (decimal)
• \( Foreign\ Interest \) — Interest rate in the foreign country (decimal)

Explanation: The formula shows how interest rate differentials between two countries affect the forward exchange rate.

3. Importance of Interest Rate Parity

Details: IRP is fundamental in foreign exchange markets and international finance. It helps predict future exchange rates and is used in hedging strategies and arbitrage opportunities.

4. Using the Calculator

Tips: Enter the current spot exchange rate, domestic interest rate (as decimal), and foreign interest rate (as decimal). All values must be valid (spot rate > 0, interest rates ≥ 0).

5. Frequently Asked Questions (FAQ)

Q1: What's the difference between covered and uncovered interest rate parity?
A: Covered IRP uses forward contracts to hedge exchange rate risk, while uncovered IRP assumes no hedging.

Q2: Does interest rate parity always hold in real markets?
A: No, due to transaction costs, political risks, and market imperfections, deviations can occur.

Q3: How does inflation affect interest rate parity?
A: Higher inflation typically leads to higher interest rates, which affects the parity calculation.

Q4: What time period does this calculation apply to?
A: The calculation applies to the same time period as the interest rates (usually annualized rates).

Q5: Can this be used for currency forecasting?
A: While useful, other factors like political stability and economic growth also affect exchange rates.