The theory of interest rate parity

The movement of short-term funds between two countries to take advantage of interest differentials is a major determinant of the spread between forward and spot rates. According to the interest parity theory, the spread between a forward rate and a spot rate should be equal but opposite in sign to the difference in interest rates between two countries. In a free market, the currency with the higher interest rate would sell at a discount in the forward market, while the currency with the lower interest rate would sell at a premium in the forward market. In fact, the forward discount or premium is closely related to the interest differential between the two currencies.

The interest rate parity theory holds that the difference between a forward rate and a spot rate equals the difference between a domestic interest rate and a foreign interest rate:

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