Interest Rate Parity

Interest rate parity is like you having a good hair day. It’s a theory, and it doesn’t always exist (but sometimes does).

To be able to spot a parity, we’re looking at interest rates in two different countries that trade capital easily with each other. Interest rate parity is the theory that the difference between the interest rates of two countries is due to the expected appreciation or depreciation of the currency.

For instance, say there’s Little Pony Kingdom and Big Bird Kingdom, and they both allow their people to invest in each other’s banks and currencies. If Little Pony kingdom’s interest rate was 5% and Big Bird kingdom’s interest rate was 7%, then interest rate parity theorizes this is because investors expect Little Pony currency to appreciate by 2%, or Big Bird currency to depreciate by 2%.

The idea is that, if investors could make more money simply by putting their money into higher interest rate accounts, they would (and do). In countries that swap money like it ain’t no thang, you’d think everyone would be putting their money in the “smarter” place where it’d make more money. But, of course, some currencies are more stable than others. So the theory is that investors stay in lower interest investments if they think that currency will be worth more in the future.

The idea is that the returns from investing in either country should be the same, regardless of their interest rates. Forex traders that try to find the better place to park their cash use parity to make more money (well, they try, anyway).