Interest Rate Parity

The interest rate parity theory helps describe the relationship between foreign exchange rates and interest rates. According to the theory of interest rate parity (IRP) the difference in national interest rates for financial securities and derivatives of similar risk and maturities should be equal to the forward rate discount or premium for the foreign currency.

This means that when an investor is choosing between whether to invest in the domestic market or in a foreign market, the returns would be approximately equal, given that the risks and maturities of the securities are similar.

What this means is that differences in national interest rates help set the forward rates at which financial securities are set.

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