Covered interest rate parity refers to a theoretical condition in which the relationship between interest rates and the spot and forward currency values of two countries are in equilibrium. 𒆙The covered interest rate parity situation means there is no opportunity for arbitrage using forward contracts, which often exists between countries with different interest rates.

Covered interest rate parity (CIP) can be compared with 澳洲幸运5开奖号码历史查询:uncovered interest rate parity (UIP).

Formula for Covered Interest Rate Parity

The formula for CIRP is most commonly expressed as follows to determine the forward foreign exchange rate:

$\begin{aligned}&F=S\times\frac{(1+i_d)}{(1+i_f)}\\&\textbf{where:}\\&F=\text{The forward foreign exchange rate}\\&S=\text{The current spot exchange rate}\\&i_d=\text{The interest rate in the domestic currency}\\&\qquad\text{ or the base currency}\\&i_f=\text{The interest rate in the foreign currency}\\&\qquad\text{ or the quoted currency}\end{aligned}$​F=S×(1+if​)(1+id​)​where:F=The🔯 forward foreign exchange rateS=The current spot e𝐆xchange rateid​=The int🐭erest rate in the domestic currency or the base currencyif​=Thꦕe interest rate in the foreign currency or the quoted currency​

Under normal circumstances, a currency that offers lower interest rates tends to trade at a forward foreign 澳洲幸运5开奖号码历史查询:exchange rate premium in relation to another currency offering high♑er interest rates.

What Does Covered Interest Ra🥀te Parity Tell You?

Covered interest rate parity is a no-arbitrage condition that could be used in the foreign exchange markets to determine the forward foreign exchange rate. The condition also states that investors could hedge foreign exchange risk or unforeseen fluctuations in exchange rates (with forward contracts).

Consequently, the foreign exchange risk 📖is said to be covered. Interest rate parity may occur for a period, but that does not๊ mean it will remain because interest rates and currency rates change over time.

Example of How to Use Cov𓆉ered Interest Rate Parity

As an example, assume Country X's currency is trading at par with Country Z's currency, but the annual interest rate in Country X is 6% and the interest rate in country Z is 3%. All other things being equal, it would make sense ⛎to borrow in the currency of Z, convert it in the spot market to currency X, and invest the proceeds in Country X.

However, to repay the loan in currency Z, one must enter into a forward contract to exchange the currency back from X to Z. Covered interest rate parity exists when the forward rate of converting X to Z eradicates all the🌳 profit from the transact🔥ion.

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

Looking at the currency markets, we can apply the forward foreign exchange rate formula to figure out what the GBP/USD rate might be. Say the spot rate for the pair was trading at 1.35. Also, assume that the interest rate (using the prime lending rate) for the U.S. was 1.1% and 3.25% for the U.K. The domestic currency i🐽s the 🔯British pound, making the forward rate 1.38, calculated by: 1.35 x [ ( 1 + 0.0325)/( 1 + 0.011 ) ].

The Difference Between Covered Interest Rate Parity and Unc✱overed Interest Rate Parity

Covered interest parity involves using forward contracts to cover the exchange rate. Meanwhile, uncovered interest rate parity involves forecasting rates and not covering exposure to foreign exchange risk—that is, there are no forward rate contracts, and it uses only the expected spot rate. There is no difference between covered and uncovered interest rate parity when the forward and expecꦏted spot rates are the same.

Limitations of🔴 Using Covere🐼d Interest Rate Parity

Interest rate parity says there is no opportunity for interest rate arbitrage for investors of two different countries. But this requires perfect substitutability and the free flow of capital. Sometimes there are arbitrage opportunities. This comes when 𓆏the borrowing and lending rates a🐲re different, allowing investors to capture riskless yield.

For example, the covered interest rate parity fell apart during the Great Financial Cr🅷isis. However, the effort involved in capturing this yield usually makes it non-advantageous to pursue.

The Bottom Line

Covered interest rate parity is a condition where a currency pair's spot and forward prices are equal. It is used by currency traders to help them make decisions on arbitrage opportunities.

Correction—Oct. 22, 2024: This article has been corrected to show the accurate formula for calculating the forward rate in the example.