What is interest rate parity? Why forward rates differ from today's rate
By SendPay Business · · 2 min read
Interest rate parity is the idea that the difference in interest rates between two currencies is reflected in the gap between today's exchange rate and the forward rate for a future date. It explains why a forward rate is almost never the same as the spot rate.
The basic idea
If you could earn more interest by holding one currency, everyone would buy it today and lock in a forward rate to swap back later. To stop that being free money, the forward rate adjusts. The currency with the higher interest rate trades at a weaker forward rate, and the lower-rate currency trades at a stronger one.
A simple example
- Say pound interest rates are higher than euro rates by 1% a year.
- Then a one-year forward rate for GBP/EUR will be roughly 1% lower than today's spot rate.
- The difference is often quoted in 'forward points'.
Why it matters to businesses
When a business books a forward contract to fix the rate for a future payment, the price it gets is based on this interest rate gap plus the provider's margin. It isn't a forecast of where the rate will go. Knowing this helps you judge whether a quote is fair.
Where SendPay fits
SendPay platforms let customers hold GBP, EUR and USD and exchange between them at a fee the platform owner sets, powered by licensed partners. SendPay doesn't offer trading.
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Build my platform →Questions people ask
Can I work out a forward rate myself?
Our free forward exchange rate calculator works out the forward rate and forward points from the spot rate and each currency's interest rate.
Forward rate calculator →What is a forward contract?
An agreement to exchange currency at a fixed rate on a future date.
Forward contracts →What is a carry trade?
Borrowing in a low-rate currency to invest in a higher-rate one.
Carry trades →How do interest rates affect exchange rates?
Higher rates can attract foreign money and lift a currency.
Interest rates and currencies →Read next
This guide is general information, not legal or financial advice. SendPay Business is a technology company, not a bank, and does not take deposits; regulated services on the platforms are provided by licensed partners. PayPal, Patreon and Substack are named as reference points only and are not affiliated with SendPay Business.