Interest Rate Parity (IRP) — The Promise Between Rate Gaps and Forwards
If Korea's rate is 3% and the U.S. rate is 5%, do you earn 2 percentage points extra for free by converting to dollars and depositing in the U.S.? The market is not that easy. The principle by which that 'free lunch' disappears is exactly interest rate parity.
Why does risk-free arbitrage disappear
Interest Rate Parity (IRP) is a basic principle of international finance: 'the interest-rate gap between two countries is ultimately reflected in the difference between the spot and forward exchange rates.'
The intuition is this. If you could surely earn more just by putting money in the higher-yielding currency, funds worldwide would rush there and that opportunity would vanish in an instant. The market does not leave such 'risk-free arbitrage' alone for long.
The mechanism that balances it is the 'forward rate.' The forward rate adjusts so that a high-rate currency is set to fall in value in the future (forward discount) and a low-rate currency is set to rise in the future (forward premium). As a result, once exchange-rate risk is eliminated, the return is the same whichever currency you put money into.
Source: Corporate Finance Institute 'Covered Interest Rate Parity (CIRP),' AnalystPrep 'International Parity Conditions.'
The covered IRP formula
The version in which exchange-rate risk is 'covered' with a forward contract is called covered interest rate parity. The formula is as follows.
F / S = (1 + r_domestic) / (1 + r_foreign)
Here F is the forward rate, S is the spot rate, and r_domestic and r_foreign are the interest rates of the two countries respectively.
For example, if the domestic rate is low and the foreign rate is high, then by this formula the forward rate (F) is set lower than the spot rate (S). In other words, the high-rate currency is pre-reflected as falling in value in the future, so the gain earned from interest is offset by the exchange-rate loss.
If this relationship breaks (the formula does not hold), banks immediately step in with arbitrage and push it back to balance. This is also observed as the 'cross-currency basis.'
The difference between covered and uncovered
Covered IRP is the case where 'exchange-rate risk is eliminated with a forward,' so it holds almost exactly in theory. This is where the idea comes from that hedging causes the interest-rate-gap gain to disappear into hedging cost.
By contrast, 'uncovered IRP' is the unhedged case, relying on the expectation that 'a high-rate currency will fall in value in the future by that much.' But in reality this expectation often misses — high-rate currencies frequently keep strengthening instead. This mismatch is exactly the backdrop for why the 'carry trade' has earned money on average, and it is academia's 'forward premium puzzle.'
In short, eliminate exchange-rate risk (covered) and there is no free lunch; take on the risk (uncovered) and you may earn on average, but you can lose big in a crisis.
Preguntas frecuentes
Q. So is currency hedging a loss?
Rather than a loss, it is 'a trade that pays a cost equal to the interest-rate gap to eliminate exchange-rate risk.' If you currency-hedge a high-rate-currency asset (e.g., the dollar in the past) into won, the hedging cost equal to that rate gap tends to reduce returns. In exchange, it protects you from losses even if the exchange rate moves unfavorably. Think of it as the price of buying safety.
Q. Does IRP actually hold exactly in practice?
Covered IRP holds very well in a normal market. However, in extreme situations like the 2008 financial crisis, dollars became hard to obtain and a 'basis' deviating from the formula opened up. Uncovered IRP frequently deviates in reality, and this is both the source of carry trade profits and the root of their risk.
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