{“type”:“Markdown”,“value”:"# Unlocking the Mystery of Covered Interest Rate Parity
Covered interest rate parity refers to a theoretical condition where the relationship between interest rates and the spot and forward currency values of two countries are balanced. When this equilibrium exists, there is no opportunity for arbitrage by utilizing forward contracts, often observed between countries with differing interest rates.
Key Takeaways
- Covered interest rate parity (CIP) establishes that the relationship between interest rates and spot and forward currency values of two countries are in a balanced state.
- It denotes no arbitrage opportunities through forward contracts.
- CIP and uncovered interest rate parity (UIP) equate when forward and expected spot rates coincide.
Formula for Covered Interest Rate Parity
To determine the forward foreign exchange rate, CIP is commonly expressed through the following formula:
\[ F = S \times \left( \frac{1 + i_d}{1 + i_f} \right) \]
Where:
- F: The forward foreign exchange rate
- S: The current spot exchange rate
- i_d: The interest rate in the domestic currency or the base currency
- i_f: The interest rate in the foreign currency or the quoted currency
Typically, a currency offering a lower interest rate is traded at a forward exchange rate premium relative to a currency with a higher interest rate. While various methods exist for calculating the forward foreign exchange rate, the above method is predominant.
What Does CIP Tell You?
CIP is a no-arbitrage condition instrumental in the foreign exchange markets for determining forward foreign exchange rates. It illustrates that investors can hedge foreign exchange risk or unforeseen currency rate fluctuations using forward contracts. Hence, foreign exchange risk is considered covered. CIP might persist temporarily but will change as interest rates and currency values fluctuate over time.
Example of CIP in Practice
Imagine Country X\u2019s currency equals Country Z\u2019s currency in the spot market, but Country X has an annual interest rate of 6%, and Country Z has 3%. Assuming all factors are consistent, borrowing in currency Z, converting it to currency X in the spot market, and investing the proceeds in Country X seems profitable.
To repay the loan in currency Z, entering a forward contract to exchange X to Z is necessary. CIP exists when the forward rate for X to Z nullifies any profit from these transactions.
For instance, should the currencies be traded at par, one unit of Country X\u2019s currency equals one unit of Country Z\u2019s currency. Assuming the domestic currency is Country Z\u2019s, the forward rate is 0.97, calculated by:
\[ 1 \times \frac{( 1 + 3\text{%} )}{( 1 + 6\text{%} )} \]
Analyzing hypothetical currency markets, if the spot rate for GBP/USD was 1.35, with U.S. interest rate at 1.1% and U.K. at 3.25%, the domestic currency being the British pound, the forward rate becomes 1.32, determined by:
\[ 1.35 \times \left( \frac{1 + 0.011}{1 + 0.0325} \) \\]
Difference Between Covered and Uncovered Interest Rate Parity
Covered interest parity utilizes forward contracts to safeguard exchange rates. In contrast, uncovered interest rate parity foregoes forward rate contracts, relying solely on expected spot rates and leaving foreign exchange risk exposed. When forward and expected spot rates are identical, covered and uncovered interest rate parity align.
Limitations of CIP
Interest rate parity implies no arbitrage opportunities for investors across different countries, relying on perfect capital substitutability and free capital flow. Occasionally, arbitrage opportunities arise, notably through disparate borrowing and lending rates, often eroded by realistic constraints like the Great Financial Crisis, which showcased CIP\u2019s failure.
Common Questions about CIP
What is the covered interest rate parity? It’s a theoretical state when the spot and forward currency values of a pair reach equilibrium, indicating no arbitrage opportunity.
What are the two types of interest rate parity? The two types are covered and uncovered interest rate parity. Covered uses forward or futures contracts while uncovered involves only expected spot rates.
When does interest rate parity not hold? It fails when the spot and forward prices aren\u2019t balanced, indicating an arbitrage opportunity.
Conclusion
Covered interest rate parity is a critical condition signifying a currency pair\u2019s spot and forward prices match, providing pivotal insights for currency traders and informing potential arbitrage opportunities in fluctuating markets.
Related Terms: Uncovered Interest Rate Parity, Forward Rate, Spot Rate, Arbitrage, Interest Rate.
References
- CME Group. “Covered Interest Parity, Implied Forward FX Swaps, Cross Currency Basis, and CME €STR Futures”.
