Interest Rate Parity is a theory that attempts to explain the relationship between interest rates and foreign exchange rates by demonstrating that hedged returns in different currencies should be identical, regardless of exchange rate differentials or levels. The concept is expressed both in terms of “covered” and “uncovered” interest rate parity.

In order to fully grasp the concept of interest rate parity, the forex trader must first grasp the concept of forward exchange rates as distinct from spot, or current, exchange rates. Forward rates are a specific rate calculated for a point in time in the future, and are arrived at utilizing a very specific mathematical formula incorporating spot exchange rates for the two currencies in question as its starting point. The difference between the spot rate and the forward rate for any currency is known as the “swap point”: if the swap point is positive, then the currency is said to have a forward premium; if negative, then the currency has a forward discount. Currencies with a lower interest rate will trade at a forward premium while currencies with a higher interest rate will trade at a forward discount.

Traders and investors who adhere to the theory of covered interest rate parity believe that the profits that are supposedly to be made when entering into a forex carry trade position are not real, because the trader must, as a hedge against exchange rate risk, enter into a forward forex contract to “cover” his exchange rate exposure. The purpose of the forward contract is to convert his proceeds back into the lower-yielding currency in which he originally borrowed, so that he can pay off his obligation to his “lender”. This effectively results in the trader’s profits being just equal to what he would have earned at the lower interest rate of the currency which he leveraged, because the cost of his “cover” will have negated his profits. Such investors tend to keep their capital in their home country since, according to the theory of covered interest rate parity, forward premiums offset interest rate differentials.

Those who espouse the uncovered interest rate parity theory assume that the change in the currency pair’s exchange rate over the life of the forex contract—the forward premium or forward discount—will be equal to the difference in the two countries’ prevailing interest rates. In reality, however, this often does not wind up being so, rather, increased borrowing in the lower-yielding currency ultimately serves to weaken it, correspondingly enhancing the value of the forward discount currency in the pair. As the lower-yielding currency continues to depreciate and interest rates rise, the higher-yielding currency tends to appreciate, skewing the exchange rate differential to a level greater than the difference between the interest rates. Since the expected appreciation of the second currency is offset by lowered interest rates, investors believing in uncovered interest rate parity will also tend to keep their capital in their home country.

If you believe that the interest rate parity theory works, then no matter whether you invest at home or abroad, you will expect your returns to be the same. If you reject the notion of interest rate parity, then you should use forward forex contracts to hedge against exchange rate risk, and monitor interest rates and depreciation so that you can close out your position if and when it appears that your gains could be wiped out by the costs of having made them.