Interest Rate Parity
a.k.a. IRP, Covered interest parity
The principle that the difference between two countries' interest rates should equal the gap between the forward and spot exchange rates.
Interest rate parity says you cannot earn a free lunch by borrowing in a low-rate currency and depositing in a high-rate one while locking in the exchange rate with a forward. The forward price adjusts to cancel out the rate gap.
The covered version, which uses forwards, holds closely in normal markets thanks to arbitrage, with small, telling breakdowns in times of stress. The uncovered version, which says the high-yield currency should depreciate, often fails in practice, which is why carry trades can work for long periods.
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