Interest Rate Parity

Interest-rate parity holds that the interest-rate differential (cf.) between like-for-like investments in two currencies equates to the differential between the spot and forward exchange rates of the currency pair. Parity derives from the notion that investing in different currencies yields the same return notwithstanding differences in interest rates. In other words, an investor depositing cash in low-yielding currency A today for one year and converting the funds at maturity into high-yielding currency B would earn the same return as an investor converting the funds today to currency B and exchanging the proceeds into currency A at maturity, since under the IRP concept, the forward FX rate would compensate for the difference in interest rates.