What does the term 'Interest rate parity' primarily relate to?

Interest rate parity is an essential concept in international finance that describes the relationship between interest rates and exchange rates. It asserts that the difference in interest rates between two countries is equal to the expected change in exchange rates over the same period. This ensures that investors do not earn arbitrage profits from cross-border investments by taking advantage of differing interest rates.

The primary focus of interest rate parity is on the relationship between the spot exchange rate and the forward exchange rate. When interest rates diverge in different countries, the forward exchange rate is adjusted accordingly to reflect that difference. If it did not adjust, arbitrage opportunities would exist, allowing investors to exploit discrepancies between the two markets. Hence, understanding this relationship is crucial for assessing currency risk and making informed investment decisions in the global market.

The other options do not pertain directly to interest rate parity. The balance of payments is a broader economic measure of trade and financial transactions between countries. Federal monetary policy refers to a country's strategy for managing its currency, money supply, and interest rates, which influences but does not directly define the parity. Tariff regulations deal with trade barriers and do not relate to interest rates or currency values in the same way.