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
where
In formula [1], the interest rates are assumed to be annually compounded commercial rates, such as Libor rates. If they are continuously compounded, formula [1] becomes:
where
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.
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s is the spot exchange rate, expressed as the price in
currency a of a unit of currency b;
and
are continuously compounded rates, and e is the natural log base
(2.718281828...).
