Table of Contents
- Introduction to Covered Interest Rate Parity
- Key Takeaways
- How to Calculate Covered Interest Rate Parity
- Fast Fact
- Understanding the Implications of Covered Interest Rate Parity
- Practical Example of Applying Covered Interest Rate Parity
- Comparing Covered vs. Uncovered Interest Rate Parity
- Limitations and Challenges of Covered Interest Rate Parity
- What Is the Covered Interest Rate Parity?
- What Are the 2 Types of Interest Rate Parity?
- When Does Interest Rate Parity Not Hold?
- The Bottom Line
Introduction to Covered Interest Rate Parity
I want you to understand that covered interest rate parity ensures no arbitrage opportunities exist by balancing spot and forward exchange rates of two countries based on their interest rates. It provides a no-arbitrage condition through the use of forward contracts, which is crucial for investors navigating different interest rate environments.
You should know that covered interest rate parity (CIP) can be compared with uncovered interest rate parity (UIP).
Key Takeaways
Covered interest rate parity (CIRP) maintains that the relationship between interest rates and spot and forward currency values of two countries is in equilibrium, eliminating arbitrage opportunities. CIRP uses forward contracts to hedge against foreign exchange risk, ensuring exchange rates are covered.
An example of CIRP is borrowing in a low-interest currency, converting it to a high-interest currency, and entering into a forward contract to eliminate potential profits. CIRP can break down when macroeconomic conditions change, such as during financial crises, despite assuming no arbitrage opportunities.
How to Calculate Covered Interest Rate Parity
The CIRP formula usually helps determine the forward foreign exchange rate. Here's the formula: F = S × (1 + i_d) / (1 + i_f), where F is the forward foreign exchange rate, S is the current spot exchange rate, i_d is the interest rate in the domestic currency or the base currency, and i_f is the interest rate in the foreign currency or the quoted currency.
A currency with lower interest rates usually trades at a forward exchange rate premium compared to one with higher rates.
Fast Fact
There are several different ways to calculate the forward foreign exchange rate, but the most common method is the one I just described.
Understanding the Implications of Covered Interest Rate Parity
Covered interest rate parity is a no-arbitrage condition that you can use 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.
As a result, the foreign exchange risk is covered. Interest rate parity can occur temporarily, but it might not last since rates change over time.
Practical Example of Applying Covered 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.
To repay the loan in currency Z, you must make a forward contract to exchange currency back from X to Z. Covered interest rate parity occurs when the forward rate for converting X to Z eliminates any profit.
Because the currencies trade at par, one unit of Country X equals one unit of Country Z. 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 is the British pound, making the forward rate 1.38, calculated by: 1.35 x [(1 + 0.0325)/(1 + 0.011)].
Comparing Covered vs. Uncovered Interest Rate Parity
Covered interest parity uses forward contracts to secure the exchange rate. Uncovered interest rate parity forecasts rates without covering foreign exchange risk, using only the expected spot rate. There is no difference between covered and uncovered interest rate parity when the forward and expected spot rates are the same.
Limitations and Challenges of Covered Interest Rate Parity
Interest rate parity means investors from two countries can't easily profit from rate differences. It requires perfect substitutability and free capital flow. Sometimes there are arbitrage opportunities. This comes when the borrowing and lending rates are different, allowing investors to capture riskless yield.
For example, the covered interest rate parity fell apart during the Great Financial Crisis. However, the effort involved in capturing this yield usually makes it non-advantageous to pursue.
What Is the Covered Interest Rate Parity?
The covered interest rate parity is a theoretical occurrence where a pair's spot and forward currency prices are equal, representing no arbitrage opportunity.
What Are the 2 Types of Interest Rate Parity?
The two types are covered and uncovered. The difference is that the covered type uses forward or futures contracts, while the uncovered uses expected spot rates.
When Does Interest Rate Parity Not Hold?
Interest rate parity does not hold when the spot and forward prices are not in equilibrium, representing an arbitrage opportunity.
The Bottom Line
Covered interest rate parity occurs when the spot and forward currency exchange rates of a currency pair are equal, eliminating any arbitrage opportunities. This no-arbitrage condition helps currency traders in hedging foreign exchange risk using forward contracts. However, arbitrage opportunities can arise when interest rates and currency rates shift, underscoring the dynamic nature of financial markets.
Correction—Oct. 22, 2024: This article has been corrected to show the accurate formula for calculating the forward rate in the example.
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