Forex glossary
Interest Rate Parity (IRP)
Interest rate parity relates two currencies' interest rates to exchange rates. Covered parity (CIP) links rates, spot and contracted forward rates under no-arbitrage assumptions. Uncovered parity (UIP) concerns expected spot changes and requires additional assumptions; it does not guarantee carry-trade returns or a future spot rate.
Illustrative example
How does it work in practice?
Suppose spot is 1.00 USD per EUR and annual rates are 4% for USD and 2% for EUR. A frictionless CIP model gives a forward rate near 1.0196 USD per EUR, not a spot forecast.
A case to work through
Quotation determines the formula
Hypothetical spot is 1.10 USD per EUR; simple annual USD and EUR rates are 4% and 2%.
- Calculate forward 1.10 × 1.04 ÷ 1.02 ≈ 1.12157 USD per EUR.
- Its premium over spot is about 1.9608%.
What follows? Label numerator and denominator currencies before calculating.
Example boundary: The model excludes basis, credit risk, costs and differing interest conventions.
Quotation first
Text description of the diagram
- Spot: 1.10 domestic units per one foreign unit.
- Simple annual rates: Domestic 4%, foreign 2%, one year.
- Forward benchmark: 1.10 × 1.04 ÷ 1.02 ≈ 1.12157.
A useful distinction
Interest Rate Parity (IRP) / Carry Trade
CIP contracts a forward exchange rate; unhedged carry retains spot risk.
Change an assumption, see the result
What changes if…?
The CIP model quotes domestic currency per one foreign unit. With spot 1.1000, simple annual rates of 4% and 2%, and one year, forward is 1.1215686 and premium 1.96078%. It excludes basis, credit and costs; it is a benchmark rather than a spot forecast.
Covered-parity benchmark: F = S × (1 + quote rate × time) ÷ (1 + base rate × time), rates as fractions. Simple interest; both growth factors must be positive. Cross-currency basis, costs, credit risk and day-count conventions are excluded. This is neither a future spot forecast nor an executable quote.
Check your understanding
Apply CIP with the correct quote direction.
Show the answer and explanation
No, it is a conditional forward benchmark
Future spot is a different quantity.
Rates, exposures and market measures
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Related terms
Sources and documentation
- BIS — Covered interest parity lost: understanding the cross-currency basis
Covered interest parity as a benchmark, and reasons real forwards can deviate. This is not a future spot forecast.
Document read: - bis.org
The example illustrates the mechanism. Check current account conditions and instrument specifications with the provider.