The interest rate parity (IRP) demonstrates the relationship between the interest rates and the exchange rate of two countries. This relationship states that if interest rate parity were to hold, the forward exchange rate should be equal to the spot exchange rate times the interest rate of the home country divided by the interest rate of the foreign country. The IRP shows that interest rates can determine what future exchange rate or expected exchange rate should be if currencies are in equilibrium. The idea behind the interest rate parity is that if the currencies and interest rates are in equilibrium, there should be no arbitrage opportunity. If IRP does not hold, then you could employ an arbitrage strategy by borrowing money, exchanging it at the spot rate, investing at the foreign country's interest rate, and locking into a forward contract. At the date of maturity, you would withdraw your money and use the forward contract to exchange the foreign currency back into your home currency. You would then pay back the money and still have made a profit. The interest rate parity relationship is often referred to as being covered or uncovered. When the no-arbitrage condition is held without a forward contract, this is referred to as the uncovered IRP. In this scenario, the expected spot exchange rate is based on interest rates according to IRP. When the no-arbitrage condition is held with the use of a forward contract, this is referred to as the covered IRP. The equations for these concepts are very similar with the only difference being the substitution of the expected spot exchange rate for the forward exchange rate. The IRP equation can be rearranged in a number of ways to show how they interact. In this calculator, you can easily enter information to see how each component of IRP is related. By leaving either the home country interest rate, foreign country interest rate, spot exchange rate, or forward exchange rate blank, this calculator will show you the missing value in order for interest rate parity to hold.
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