Interest rate parity

Interest rate parity is the relationship among interest rates, spot exchange rates, and forward exchange rates that prevents risk-free arbitrage between currencies.

Covered interest parity: A no-arbitrage condition equating hedged returns from deposits in two currencies. It expresses parity when foreign-exchange risk is covered with a forward contract.
Foreign exchange market: A global network for trading currencies and currency-linked financial contracts. Interest rate parity describes a no-arbitrage relationship within this market.
Forward contract: A private agreement to exchange an asset at a specified price on a future date. Currency forward contracts provide the hedge used to test covered parity.
Purchasing power parity: A theory linking exchange rates to relative price levels across countries. It concerns goods-price differences, unlike interest rate parity's financial returns.
Global financial crisis: The 2007–2009 crisis marked by severe disruptions in international finance and banking. During the crisis, funding stress contributed to unusually large deviations from covered parity.
Uncovered interest parity: A condition linking interest-rate differences to expected changes in the exchange rate without forward hedging. It applies the parity idea when investors leave currency risk unhedged.
Interest rate: The cost of borrowing money or the return earned on lending or depositing it over time. Different currency interest rates create the return gap that parity must reconcile.
Currency swap: An agreement to exchange cash flows in different currencies under specified terms. Swap pricing is linked to the same cross-currency funding relationships as covered parity.
Fisher effect: The proposition that nominal interest rates reflect real interest rates and expected inflation. It explains interest rates through inflation expectations rather than exchange-market arbitrage.
Dollar funding: The borrowing and provision of U.S. dollars through domestic and international financial markets. Dollar shortages can raise the cost of obtaining dollars through currency swaps.

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