# Interest Rate Parity (IRP).

IRP is an economic theory that states that the interest rate differential between two countries should be equal to the difference between the expected inflation rates of those countries. In other words, the interest rate in one country should equal the interest rate in another country plus or minus the expected inflation rate in that country.

IRP is often used by investors to determine whether it is more advantageous to invest in one country or another. For example, if Country A has an interest rate of 3% and an expected inflation rate of 2%, while Country B has an interest rate of 5% and an expected inflation rate of 4%, then, according to IRP, investing in Country A is more advantageous than investing in Country B. This is because, after taking into account the expected inflation rates, the real interest rate in Country A is 1% (3% - 2%), while the real interest rate in Country B is only 1% (5% - 4%).

There are a number of factors that can cause the interest rate differential to diverge from the expected inflation differential, in which case the theory is said to be "violated." For example, if Country A has a higher risk of default than Country B, then investors may demand a higher interest rate from Country A in order to compensate for that risk. Alternatively, if Country A has a more flexible exchange rate than Country B, then that may also lead to a violation of IRP.

What happens if interest rate parity does not hold? If interest rate parity does not hold, it means that the interest rate differential between two countries does not equal the forward premium or discount of the currency of those countries. This can happen for a variety of reasons, including changes in central bank policy, different levels of economic growth, or different inflation rates. If interest rate parity does not hold, it can create opportunities for arbitrage, where traders take advantage of the discrepancy to make a profit. What is PPP in simple terms? In the simplest terms, PPP is the rate at which one currency trades for another. For example, if the PPP between the US and UK is 1.50, this means that for every \$1 USD you can buy £1.50 GBP.

##### What is PPP example?

The most common example of PPP is when two countries have different interest rates, and PPP suggests that the exchange rate between the two countries will adjust to equalize the prices of a identical basket of goods in each country. For example, if the interest rate in the United States is 5% and the interest rate in the United Kingdom is 3%, then, according to PPP, the exchange rate between the two countries should be such that a basket of goods that costs \$100 in the United States would cost \$105 in the United Kingdom.

### What shifts the interest parity curve?

The interest parity curve is determined by the interest rates of different countries. When the interest rate in one country increases, the interest parity curve shifts to the right. This means that the interest rate in the other country must also increase in order to maintain the same level of interest parity.

What will happen if interest rate parity IRP does not hold? Interest rate parity (IRP) is an important concept in finance that states that the interest rate differential between two countries should be equal to the forward premium or discount on the currency of the country with the higher interest rate.

If IRP does not hold, then there would be an opportunity for arbitrage, which is the simultaneous purchase and sale of an asset in order to profit from a price discrepancy. For example, if the interest rate in the United States is 2% and the interest rate in Canada is 3%, then a Canadian investor could borrow US dollars at 2% and use the proceeds to buy Canadian dollars, which would yield a 3% return. This would be an arbitrage opportunity because the investor is able to earn a risk-free return.

If IRP does not hold, then it would also mean that the forward premium or discount on the currency of the country with the higher interest rate would be greater than the interest rate differential. For example, if the interest rate in the United States is 2% and the interest rate in Canada is 3%, then the forward premium on the Canadian dollar would be greater than 1%.