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Exchange Rates in the Short Run: Interest Parity

In the short run, an exchange rate is set in the market for assets. The interest parity condition says capital flows until the expected returns on domestic and foreign deposits match once expected currency moves are counted. The domestic interest rate then equals the foreign rate minus the expected appreciation of the domestic currency.

Try it yourself

Uncovered interest parity

Set the two deposit rates. Interest parity says capital moves until both deposits offer the same expected return: i = i* − (expected appreciation of the domestic currency). So the market-implied expected currency move is just i* − i. If the foreign rate is higher, the domestic currency must be expected to appreciate by that gap to leave an investor indifferent — exactly the carry-trade break-even.

Equal expected return = i = 3.0%i* 5.0%Foreign depositrate +5.0%, FX −2.0%Domestic depositrate +3.0%
Implied expected move of the domestic currency (i* − i)
+2.0%
Domestic currency must be expected to APPRECIATE 2.0% to offset the lower domestic rate.
Domestic rate i3.0%
Foreign rate i*5.0%
Exp. return, domestic3.0%
Exp. return, foreign5.0% −2.0% FX = 3.0%
Both expected returns match. The interest-rate gap is exactly compensated by the expected currency move, so moving into the higher-yield currency offers no extra expected return — that is the carry-trade indifference.

Why it matters

An investor compares a domestic deposit with a foreign one. If the foreign rate is higher but its currency is expected to fall, the two can still offer the same expected return. Money moves across borders until they do.

Formulas

Uncovered interest parity
i=i∗−Et+1e−EtEti = i^{*} - \frac{E^{e}_{t+1} - E_{t}}{E_{t}}
ii is the domestic interest rate, i∗i^{*} the foreign rate, and EE the value of the domestic currency, so (Et+1e−Et)/Et(E^{e}_{t+1} - E_{t})/E_{t} is the expected appreciation of the domestic currency.

Worked examples

Scenario

A foreign deposit pays 5% and a domestic deposit pays 3%. For an investor to be indifferent, what must the market expect about the domestic currency?

Solution

The domestic currency must be expected to appreciate by about 2%. Then the foreign deposit’s 5% is offset by a 2% currency loss, leaving the same 3% expected return as the domestic deposit.

Common mistakes

  • ✗The currency with the higher interest rate is always the better investment. Once expected currency moves are counted, a higher rate can be exactly offset by an expected depreciation.
  • ✗Interest parity guarantees equal realised returns. It equalises expected returns, and the actual currency move can differ, which is why carry trades sometimes pay and sometimes blow up.

Revision bullets

  • •Short-run exchange rates clear the market for assets
  • •Domestic rate equals foreign rate minus expected domestic appreciation
  • •It equalises expected, not realised, returns

Quick check

A domestic deposit pays less than a foreign deposit, yet investors willingly hold both. Interest parity says the domestic currency is expected to

Connected topics

Bond MarketFX MarketPurchasing Power Parity

Sources

  1. Mishkin (2018), Ch. 18
    Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.
    The asset-market approach to exchange rates and the interest parity condition.
How to cite this page
Dr. Phil's Quant Lab. (2026). Exchange Rates in the Short Run: Interest Parity. Derivatives Atlas. https://phucnguyenvan.com/concept/mb-interest-parity
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