Understand Covered Interest Rate Parity: Formula, Calculation, and Examples

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, crucial for investors navigating different interest rate environments.

Covered interest rate parity (CIP) can be compared with uncovered interest rate parity (UIP).

How to Calculate Covered Interest Rate Parity

The CIRP formula usually helps 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 exchange rateid​=The interest rate in the domestic currency or the base currencyif​=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.

Understanding the Implications of Covered Interest Rate Parity

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).

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.

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.