In the face of a volatile international market, it's important to stay informed about all economic developments. Interest Rate Parity (IRP) is one theory that explains how changes in interest rates alter exchange rates. We'll discuss this theory and its application in our next section.Interest rate parity is a theory that explains how two countries with different interest rates will have the same exchange rate. The logic behind this theory is that if the difference in interest rates between two countries is equal to the difference in forward rates, then the two currencies should be at parity.But what does this mean practically?Let's say you live in United States and your friend lives in China. These two countries have different income levels and GDPs, but their interest rates are equally low by global standards - around 2 percent. That means there's not much of a differential between the forward and spot exchange rates, so it's safe to assume that these countries are equating their exchange rates.A theory on interest rate parity implies that the difference in interest rates between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. This theory falls under the category of International Financial Management. It says that a country's interest rates will be similar to those of other countries in cases where cross-rate adjustment is easy. However, if an adjustment isn't possible, then we can expect interest rates in one country to be different from those in another.
