Interest rate parity theory is based on the idea that interest rates in different countries influence the demand for foreign currency in forex market. Country having higher interest rates will have higher demand for that country currency in forex market.
Parity means difference or discrimination. Interest rate parity theory discriminates between two different currencies using different interest rates prevailing in different country.
Interest rates are different in different countries means that interest income on capital invested will be different in different countries. It gives the opportunity of earning risk free interest income by investing in securities in high interest rate country and converting interest income to home currency to earn higher interest income than could be earned by investing in home country.
Interest rate parity theory states that exchange rate will move to make interest income from different countries equal so that risk free income cannot be generated. Increase in investment in higher interest country will increase demand for that country currency which will lead to increase in exchange rate of that country currency. Therefore, making investment in securities in high interest rate country equally attractive to investor in low interest rate country.
Using interest rate parity theory, we can estimate forward rate for foreign currency by using interest rates of two countries as weighting for spot rate.
