Covered Interest Rate Parity

What Is Covered Interest Rate Parity?

Covered interest rate parity alludes to a hypothetical condition wherein the relationship between interest rates and the spot and forward currency values of two countries are in equilibrium. The covered interest rate parity situation means there is no opportunity for arbitrage utilizing forward contracts, which frequently exists between countries with various interest rates.

Covered interest rate parity (CIP) can measure up to uncovered interest rate parity (UIP).

The Formula for Covered Interest Rate Parity Is

$\begin &\left(1+i_d\right) = \frac$\left(1+i_f\right)\ &\textbf\ &i_d = \text\ &i_f = \text\ &S = \text\ &F = \text \end​(1+id​)=SF​∗(1+if​)where:id​=The interest rate in the domestic currency or the base currencyif​=The interest rate in the foreign currency or the quoted currencyS=The current spot exchange rateF=The forward foreign exchange rate​
The formula above can be adjusted to decide the forward foreign exchange rate:
$F=S$\frac{\left(1+i_d\right)}{\left(1+i_f\right)}
Under normal conditions, a currency that offers lower interest rates will in general trade at a forward foreign exchange rate premium comparable to another currency offering higher interest rates.

What Does Covered Interest Rate Parity Tell You?

Covered interest rate parity is a no-arbitrage condition that could be utilized in the foreign exchange markets to decide the forward foreign exchange rate. The condition additionally states that investors could hedge foreign exchange risk or unexpected variances in exchange rates (with forward contracts).

Thusly, the foreign exchange risk is supposed to be covered. Interest rate parity might happen for a period, yet that doesn't mean it will remain. Interest rates and currency rates change after some time.

Illustration of How to Use Covered Interest Rate Parity

For instance, expect Country X's currency is trading at par with Country Z's currency, yet the annual interest rate in Country X is 6% and the interest rate in country Z is 3%. Any remaining things being equivalent, it would check out to borrow in the currency of Z, convert it in the spot market to currency X, and invest the proceeds in Country X.

Notwithstanding, to repay the loan in currency Z, one must go into a forward contract to exchange the currency back from X to Z. Covered interest rate parity exists when the forward rate of switching X over completely to Z annihilates all the profit from the transaction.

Since the currencies are trading at par, one unit of Country X's currency is equivalent to one unit of Country Z's currency. Expect that the domestic currency is Country Z's currency. Thusly, the forward price is equivalent to 0.97, or 1 * [(1 + 3%)/(1 + 6%)].

Taking a gander at the currency markets, we can apply the forward foreign exchange rate formula to figure out what the GBP/USD rate may be. Say the spot rate for the pair was trading at 1.35. Likewise accept that the interest rate (utilizing the prime lending rate) for the U.S. was 1.1% and 3.25% for the U.K. The domestic currency is the British pound, making the forward rate 1.32, or 1.35 * [(1 + 0.011)/(1 + 0.0325].

The Difference Between Covered Interest Rate Parity and Uncovered Interest Rate Parity

Covered interest parity includes utilizing forward contracts to cover the exchange rate. Meanwhile, uncovered interest rate parity includes forecasting rates and not covering exposure to foreign exchange risk — that is, there are no forward rate contracts, and it utilizes just the expected spot rate. There is no difference among covered and uncovered interest rate parity when the forward and expected spot rates are something very similar.

Limitations of Using Covered Interest Rate Parity

Interest rate parity says there is no opportunity for interest rate arbitrage for investors of two distinct countries. Yet, this requires perfect substitutability and the free flow of capital. Once in a while there are arbitrage opportunities. This comes while the borrowing and lending rates are unique, permitting investors to capture riskless yield.

For instance, the covered interest rate parity went to pieces during the financial crisis. In any case, the work required to capture this yield ordinarily makes it non-beneficial to seek after.

Features

• Covered and uncovered interest rate parity are the equivalent when forward and expected spot rates are something similar.
• It accepts no opportunity for arbitrage utilizing forward contracts.
• The covered interest rate parity condition says that the relationship between interest rates and spot and forward currency values of two countries are in equilibrium.