Interest Rate Parity attempts to explain the difference between forward and spot rates as explained by differences in nominal interest rates and efficient markets will eliminate covered interest rate arbitrage opportunities.
FX/Y = SX/Y ((1+rX)/(1+rY))
- The annualized forward premium can be approximated by the difference in the two interest rates.
- When the domestic country (X) has a higher interest rate, it should sell at a forward discount as the currency is expected to depreciate; this indicates weakness.
- When the relationship between the forward and the spot rate in the formula above does not hold, an arbitrage opportunity exists. This is called covered interest rate arbitrage because the trader’s exchange rate risk is covered by the price secured in the forward contract.
