Importance of Interest Rate Parity in Forex Trading
Have you ever heard the term interest rate parity? Well, this term refers to the simple equation which governs the relationship between the currency exchange (forex) rates and interest rates. The simple standard of the interest rate parity is that the hedged returns from investing in distinct currencies really should be in the very same level, regardless of the level of the interest rates.

There are 2 distinct versions of interest rate parity:

Uncovered Interest Rate Parity

Covered Interest Rate Parity

Also, known by its abbreviation, UIP, it states the difference within the interest rates between the two countries equalizing the expected change in the exchange rate between those countries. Let us take a theoretical example. If the interest rate differential between two countries is 5%, then the currency of the nation with the higher interest rate will be expected to decline by 3%, against the currency of the other country.

Well, the fact is actually a bit different though. since floating exchange rates were introduced within the early 1970s, the countries with higher interest rates saw appreciation in their respective currencies, rather than any depreciation. This directly contradicts with the fundamental of Uncovered Interest Rate Parity.

Carry Trade perhaps can partly explain UIP equations. Speculators, in this case, borrow in low-interest currencies (For example, Yen), then sell the borrowed amount and therefore invest the proceeds in higher yielding instruments and currencies. Until mid-2007, Yen utilized to be the favorite target for this activity.

As far as Covered Interest Rate Parity is concerned, forward exchange rates need to be incorporating the difference in interest rates, between two various countries. If this doesn't happen, an arbitrage chance may exist. So, if no interest rate advantage is present when an investor borrows in a low interest rate currency for investing in a currency, it might offer much better interest rates. In general, following steps are taken by the investor:He will borrow an amount within the currency with lower interest rate.

Next, the borrowed amount will likely be converted into the currency with higher interest rate.

Trader now invests the proceeds in an interest bearing instrument in the higher interest rate currency.

The trader simultaneously hedge exchange risk by buying forward contracts, in an attempt to convert the investment proceeds into the lower interest rate currency.

The cost of hedging exchange risk negates the higher returns in case of Covered Interest Rate Parity Condition.