What is the interest rate parity theory?

[Holicent]

Interest rate parity theory is a theory that helps to explain the relationship between exchange rates and interest rates. The theory states that over the long term, the difference between two countries interest rates should be equal to the difference in their exchange rates. This means that if one country has a higher interest rate than another, investors will buy its currency because they can earn more by investing in that country's assets.

However, if this goes on for too long, investors will start selling off assets from one country and move them into assets from another country until equilibrium is restored. Interest rate parity theory was first proposed by Swedish economist Knut Wicksell in 1898. It was further developed by John Maynard Keynes in 1921 as part of his work on foreign exchange markets and international finance.

 

[Suba]

Yeah bro, you're right, the difference in interest rates between two countries tends to be the same (not necessarily) with the forward premium rate assuming no transaction costs, also this theory often doesn't apply to third countries because the relationship between depreciation rates and interest rates is often negative in the short term. . Forex traders often use this IRP theory to calculate the USD fair exchange rate.

 

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