Interest Rate Parity

Interest rate parity is the principle linking the interest-rate gap between two currencies to the difference between their spot and forward exchange rates. In its covered form, the forward rate is set so that borrowing in a low-rate currency, converting, and depositing in a high-rate currency earns no risk-free profit once the currency is hedged forward — otherwise arbitrage would close the gap. The concept explains why forward prices and swap points reflect interest-rate differentials rather than a forecast of where the exchange rate will go. It also underpins the mechanics of rollover charges: holding a position past settlement effectively earns or pays the rate gap between the two currencies involved.