A financial theory that explains how differences in interest rates between two countries influence the forward exchange rate between their currencies. According to IRP, the difference in national interest rates should be reflected in the forward exchange rate so that there is no opportunity for arbitrage. 

The theory comes in two forms: covered IRP, which involves a forward contract to lock in exchange rates and eliminate risk, and uncovered IRP, which relies on expected future spot rates without hedging. In both cases, the relationship suggests that investors should earn the same return in different currencies once exchange rate movements are considered. 

For example, if U.S. interest rates are higher than eurozone rates, the dollar is expected to depreciate in the forward market relative to the euro. This adjustment ensures that investing in either currency yields the same risk-adjusted return after converting funds back at the forward rate. 

Interest Rate Parity plays a key role in pricing FX forwards, analyzing cross-currency investments, and understanding currency market dynamics. While real-world frictions like transaction costs and capital controls may cause short-term deviations, IRP serves as a foundational principle in global finance.