Interest rate parity is one of five parity conditions of Arbitrage; the interest rate parity, purchasing power parity, the fisher effect, the international fisher effect, and the unbiased forward rate. Essentially, arbitrage is an opportunity to make a profit by buying and selling an asset. Usually this process requires constant monitoring of rates in different countries. Example of such arbitrage trade would be buying an asset from China’s market for $15 dollars and selling it in some other country for $30, making a profit of $15 dollars by using the price discrepancies between the two markets.

Below is an example of a covered interest rate arbitrage (CIA), typically a preferred method for risk averse investors.

If an interest rate in the U.S is 5% per annum and in Japan is 10% per annum with an exchange rate of $1/100YEN. A risk averse investor could borrow $1,000 in U.S paying 5%, convert on spot to Japanese Yen and invest 100,000YEN in the Japanese market earning 10%. Buy a 12 month forward exchange contract to cover the risk of exchange rate fluctuations. After 12 months convert 110,000Yen back to U.S dollars (at an exchange rate of $1/100YEN, 110,000YEN=$1100.00) to get $1,100. Neglecting any transaction costs and keeping all else the same, this investor has just made risk free $100 after paying off $1,000 loan.

Uncovered interest rate arbitrage (UIP) involves the exact same steps, typically by a risk loving investor, with the exception of procuring a forward exchange rate contract. This could pay off if the exchange rate pays off more for the currency you are trying to convert into after 12 months. In other words you could buy more dollars for fewer yens; if yen has appreciated by the time you are ready to convert it back to dollars. For instance, in the example above an appreciated Japanese yen ($1/90YEN) could have earned (110,000YEN=$1222.22) $222.22 instead of $100.

Sources:

http://www.investopedia.com/articles/forex/08/interes-rate-parity.asp

http://moneyterms.co.uk/interest-rate-parity/