Interest rate parity (IRP) plays a key role in forex trading by explaining the relationship between interest rates and exchange rates of two countries. It says that the difference in interest rates between two countries should be equal to the difference between the forward exchange rate and the spot exchange rate. This concept helps traders understand currency value changes and avoid arbitrage opportunities in the forex market.

What does interest rate parity mean in simple words?

Interest rate parity means if one country has a higher interest rate than another, its currency should be cheaper in the future (in the forward market). This keeps traders from making easy profits by converting money back and forth between currencies. It balances out returns and keeps currency markets stable over time.

Why is interest rate parity important in forex trading?

IRP helps forex traders understand how currencies are priced in the forward market. If IRP holds, then there is no advantage in trading currencies just to earn interest rate differences. This avoids risk-free profit situations and ensures fair pricing of currency pairs, especially for traders doing hedging or long-term trades.

How does IRP affect forward exchange rates?

According to IRP, if a country has higher interest rates, its currency should trade at a discount in the forward market. If a country has lower interest rates, its currency trades at a premium. This means traders expect currency value to adjust over time, based on interest rate differences between two countries.

What is the difference between covered and uncovered IRP?

Covered IRP happens when traders use forward contracts to lock in future exchange rates, ensuring no loss due to rate changes. Uncovered IRP is when traders don’t hedge and expect the currency to move as per interest rate difference. Covered IRP is safer, while uncovered IRP carries more risk but also more potential reward.

How do traders use IRP in real trading?

Forex traders use IRP to check if a currency pair is fairly priced. If there is a gap between actual forward rates and IRP-calculated rates, they may trade to take advantage. But such gaps don’t last long because the market corrects quickly. IRP is also used by big firms and exporters to hedge future currency risk.

Why should Indian forex traders care about IRP?

Indian traders who trade USD/INR or other currency pairs can use IRP to understand expected price movement and avoid bad trades. It helps in planning long-term positions, hedging import-export payments, and managing forex exposure. Even small traders can benefit by knowing how global interest rates impact currency value.