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The principle by which forward currency exchange rates reflect relative interest rates on default risk-free instruments denominated in alternative currencies. Currency forward rates and interest rate structures will reflect these parity relationships. Currencies of countries with high interest rates are expected by the market to depreciate over time, and currencies of countries with low interest rates are expected to appreciate over time, reflecting (among other things) implied differences in inflation. These tendencies will be reflected in forward exchange rates as well as in interest rate structures. Any opportunity to earn a certain profit from interest rate discrepancies will be arbitraged away by hedging the currency risk. If interest rate parity holds, an investor cannot profit by borrowing in a low interest rate country and lending in a high interest rate country. For most major currencies, interest rate parity has not held during the modern floating rate regime. See also Covered Interest Arbitrage, Discount Currency, Forward Rate Bias, Premium Currency, Purchasing Power Parity (PPP).
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