Interest rate parity is a relationship that must hold between the spot interest rates of two currencies if there are to be no arbitrage opportunities. The relationship depends upon spot and forward exchange rates between the currencies. It is
s is the spot exchange rate, expressed as the price in currency a of a unit of currency b;
f is the corresponding forward exchange rate;
ra and rb are the interest rates for the respective currencies; and
m is the common maturity in years for the forward rate and the two interest rates.
where and are continuously compounded rates, and e is the natural log base (2.718281828...).
Interest rate parity plays a fundamental role in foreign exchange markets, enforcing an essential link between short-term interest rates, spot exchange rates and forward exchange rates.