# Interest rate parity theorem

• Interest rates in different countries are generally different because of the differences in inflation rates. Interest rate parity holds if the differences in interest rates are exactly offset by differences in inflation rates and the resulting currency depreciation. Assume that the risk-free interest rate in the US is 5% and in Mexico 15%. Assume that it takes 10 pesos to USD now and one-year forward price is 10.952381 MP/USD. If you invest \$1000 now, next year, you end up with \$1050 USD. If you convert \$1000 into pesos now, you end up with 10,000 MP, lend them at 15%, and end up with 11,500 MP, convert them back into USD at the forward price of 10.95, you end up with exactly \$1050 USD next year, which is exactly the same as if you lent in the US. This is an example of interest rate parity.

• Interest rate differential between two countries is equal to the difference between the forward foreign exchange rate and the spot rate.

Embedded terms in definition
Currency
Depreciation
Exchange rate
Exchange
Foreign exchange rate
Foreign exchange
Foreign
Forward
Inflation
Interest rate
Interest
Lend
Offset
Parity
Spot rate

Related Terms

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