Interest Rate Parity (IRP)

Interest Rate Parity (IRP) is a fundamental theoretical relationship in international finance that states the difference in interest rates between two countries should equal the expected change in the exchange rate between their currencies over the same period — ensuring that arbitrage-free equilibrium is maintained between money markets and currency markets. In the covered IRP framework: Forward Exchange Rate = Spot Rate × (1 + Domestic Interest Rate) ÷ (1 + Foreign Interest Rate). This means that a country with higher interest rates should see its currency depreciate in the forward market by approximately the interest rate differential — so any gain from investing in the higher-yielding currency is exactly offset by the cost of the forward hedge. For the USD/INR currency pair, India's structurally higher interest rates relative to the US mean that the rupee is expected to depreciate against the dollar over time — reflected in the forward premium on USD/INR. Indian exporters using forward contracts to hedge their USD receivables are essentially locking in the interest rate differential as the forward rate premium. Understanding IRP is essential for Indian corporate treasurers managing cross-currency exposures, fund managers evaluating international investment returns on a currency-hedged basis, and macro investors analysing the relationship between RBI and Fed rate differentials and their implications for the rupee's exchange rate trajectory.