Interest Rate Parity (IRP) is a major macroeconomics finance course that is included in the university curriculum. The IRP theory helps in the understanding of the value, exchange, and trading of currency in the global market. IRP helps individual and institutional traders who are involved in the foreign exchange market and who are actively trading with their forex account to understand the relationship and differences between interest rates and exchange rates.

What is Interest Rate Parity?

The essence of the Interest Rate Parity is to connect the interest rate of a country to how the currency is expected to move in the foreign exchange market. There are two major versions of the Interest Rate Parity theory, which are the covered interest rate parity and the uncovered interest rate parity.

1. Covered Interest Rate Parity (CIP): The CIP means that when the spot exchange rate is compared or deducted from the forward exchange rate, the result should be the same as the interest rate between the two countries whose currencies are compared. If the result is not the same as the interest rate between the two countries, traders would often exploit each other by mis-pricing. This exploitation is called an arbitrage opportunity. This theory explains the use of forward contracts by investors to eliminate risk.
2. Uncovered Interest Rate Parity (UIP): Forward contracts are not used under this version of the theory. It, however, states that the spot-exchange expected movement will be the same as the differences between the interest rates of the compared countries’ currencies. Traders usually violate this version because of the possibility of premium risks and market expectations.

Real-World Application: Forward Markets and Hedging.

A detailed and practical example will aid in the understanding of the theory. If the interest rate in the US is about 5% and the interest rate of the Eurozone is about 3%. the Covered IRP version of the theory states that, assuming the spot exchange is calculated to be 1.10 USD/EUR, then there is an almost accurate prediction that the one-year forward rate should be around 1.078 USD/EUR. The purpose of this is to prevent an investor from investing in a profitable trade that has no risk based on merely converting his dollars to euros to earn interest and looking forward to converting the euros to dollars in one year.

Forex traders and many global institutions have adopted this means to manage their currency risk by using forward contracts. An instance is when a multinational corporation that operates in Europe and the United States constantly uses IRP-forward contracts to lock future exchange rates just to protect itself from currency instability.

Arbitrage and Market Discipline.

Arbitrage and Market Discipline is an alternative to the covered interest rate parity. It is used when the CIP doesn't hold. If the forward rate has predicted that the profit on Euros will be greater than the suggested interest rate differences, traders usually borrow in US Dollars and convert to Euros, then they invest in Euros interest rate and lock in their profits by using forward contracts. This process places a downward pressure on forward rates, and this helps the market to be aligned with the IRP.

The Bank for International Settlements published a study in 2020 that established that CIP was solid among popular G10 currencies. This is especially the case for short-term maturities. Crisis like the COVID-19 pandemic, resulted in a temporary breakdown of the parity condition. This happens due to the restrictions on liquidation and the credit risks during these crisis periods, and this creates short-term arbitrage windows.

How Central Banks Influence IRP

It is essential to state that interest rates and IRPs are directly affected by the policies and actions of the Central Bank. It is noteworthy to refer back to when the USD appreciated in 2022 because the US Federal Reserve started to rapidly increase its interest rate. This caused many traders with a trading forex account to change their trading position based on the rate moves and forward rates predicted, which is explained by the IRP logic.

The changes opened new opportunities and trading challenges in the forex market. In 2022, when USD was attained a 20-year high against the Yen. The differences between the currencies are due to the interest gap between the United States, which has its rates above 4%, and Japan, whose rates are barely 0%. The gaps were identified in the forward rates, which many forex traders used to hedge or speculate in the forward market and make trading decisions.

Practical Lessons for Traders and Investors.

As a trader or investor, it is important to understand the interest rate parity for numerous reasons. Some of them include:

• To effectively speculate on the exposure of currencies.
• To access and analyze the profits of carry trades.
• To ensure that you interpret the forward rate pricing accurately.
• To ensure that you avoid making unnecessary arbitrage mistakes.

Trading websites and platforms that allow traders and investors to access the forward contracts presume that all traders understand the concept of interest rate parity. A good knowledge of IRP as an investor or a manager of a trading forex account will help you make smarter trading decisions, especially in risky situations.

Conclusion

Interest Rate Parity is not just a textbook theory. It ensures that the international financial market is functioning effectively. The balance of the forex market is sustained when the interest rate differentials are connected to the exchange rate predictions. It also helps to keep the market free of arbitrage. It has become very important for traders to have an understanding of IRP, especially with the growth of forward markets. The changes in the global interest rate are constantly changing, and traders and investors must monitor the profit curve and the exchange rate to make informed trading decisions.