The interest rate parity model is based on the concept that when a currency experiments appreciation or depreciation against another currency, this imbalance must be brought to equilibrium by a change in the interest rate differential.

The parity is needed to avoid an arbitrage condition with a risk-free return. Theoretically, it works like this: you borrow money in one currency, then exchange that currency for another currency in order to invest in interest-bearing instruments. At the same time you purchase futures contracts to convert the currency back at the end of the holding period. The amount should be equal to the returns from purchasing and holding similar interest-bearing instruments of the first currency. An arbitrage would occur if the returns for both transactions were different, thus producing a risk-free return.

Facts Box - Let's see with an example: supposing the USD has a 5% annual interest rate and the AUD 8%, the exchange rate is AUD/USD 0.7000, and the forward exchange rate implied by a contract maturing in 12 months is AUD/USD 0.7000. It is obvious that Australia has a higher interest rate than the US. The arbitrage consists in borrowing in the country with a lower interest rate and invest in the country with a higher interest rate. All else being equal, this would help you make money without any risk. A Dollar invested in the US at the end of the 12-month period will be:

1 USD X (1 + 5%) = 1.05 USD

and a Dollar invested in Australia (after conversion into AUD and back into USD at the end of the 12-month period will be:

1 USD X (0.7/0.7)(1 + 8%) = 1.08 USD

The arbitrage would work as follows:

1. Borrow 1 USD from the US bank at 5% interest rate.

2. Convert USD into AUD at current spot rate of 0.7000 AUD/USD giving 1.4285 AUD.

3. Invest the 1.4285 AUD in Australia for the 12 month period.

4. Purchase a forward contract on the 0.7000 AUD/USD (that is, covering your position against exchange rate fluctuations).

And at the end of the 12-month period:

1. 1.4285 AUD becomes 1.4285 AUD (1 + 8%) = 1.5427 AUD

2. Convert the 1.5427 AUD back to USD at 0.7000 AUD/USD, giving 1.0798 USD

3. Pay off the initially borrowed amount of 1 USD to the US bank with 5% interest, that is, 1.05 USD

The resulting arbitrage profit is 1.0798 USD − 1.0500 USD = 0.0298 USD, which is almost 3 cents of profit per each 1 USD.

The basic idea behind the arbitrage pricing theory is the law of one price, which states that 2 identical items will be sold for the same price and for if they do not, then a riskless profit could be made by arbitrage: buying the item in the cheaper market then selling it in the more expensive market.

But contrary to the theory, arbitrage opportunities of this magnitude vanish very quickly because a combination of some of the following events occurs and reestablishes the parity: the US interest rates can go up, the forward exchange rates can go down, the spot exchange rates can go up or the Australian interest rates can go down.

As we have seen in recent years during the Carry Trade, currencies with higher interest rates have characteristically appreciated rather than depreciated on the reward of future containment of inflation and of a higher yielding currency. This is the reason why this model alone is not useful either.