What Is Covered Interest Rate Parity?

August 24, 2024 3 min read Finance Economics Banking Covered Interest Rate Parity Foreign Exchange Currency Values Interest Rates Financial Equilibrium

Explore the theoretical condition of Covered Interest Rate Parity, where the relationship between interest rates and the spot and forward currency values of two countries are in equilibrium. Learn about its calculation methods, special considerations, and illustrated examples.

Covered Interest Rate Parity: Comprehensive Definition, Calculation Methods, and Illustrative Examples

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Covered Interest Rate Parity (CIRP) is a fundamental concept in international finance, describing a theoretical condition under which the differential in interest rates between two countries is exactly offset by the differential in the forward and spot exchange rates. This parity condition suggests that there is no arbitrage opportunity left unexploited.

The Equation and Calculation of CIRP

To understand CIRP mathematically, we denote:

\( F \): Forward exchange rate
\( S \): Spot exchange rate
\( i_d \): Domestic interest rate
\( i_f \): Foreign interest rate

The condition for Covered Interest Rate Parity is given by the equation:

\left(1 + i_d\right) = \left(1 + i_f\right) \times \frac{F}{S}

Rearranged to solve for the forward exchange rate, it becomes:

F = S \times \frac{1 + i_d}{1 + i_f}

Example Calculation

Assume the following:

Spot exchange rate (USD/EUR): 1.10
Domestic interest rate (USD): 2%
Foreign interest rate (EUR): 1%

Using the CIRP formula:

F = 1.10 \times \frac{1 + 0.02}{1 + 0.01} \approx 1.10 \times 1.0099 \approx 1.111

Hence, the forward exchange rate should be approximately 1.111 USD/EUR to satisfy CIRP.

Historical Context and Applicability

Covered Interest Rate Parity has its roots in the early 20th century and has been a cornerstone of foreign exchange theory. Its practical use lies primarily in the currency derivatives market, where it helps in pricing forward contracts and mitigating foreign exchange risk.

Uncovered Interest Rate Parity (UIRP): Unlike CIRP, UIRP does not require a forward contract. It relies on expected future spot rates instead.
Arbitrage: The practice of exploiting price differentials in different markets, which CIRP aims to eliminate in the context of forex markets.

Frequently Asked Questions

Is CIRP always observed in real markets?

No, CIRP might not hold due to factors like transaction costs, capital controls, and differing risk perceptions.

What happens if CIRP does not hold?

Discrepancies in CIRP indicate arbitrage opportunities, where traders can profit from differences in interest rates and exchange rates until parity is restored.

Summary

Covered Interest Rate Parity is a crucial principle in international finance that ensures no-arbitrage conditions between interest rates and currency exchange rates through forward contracts. By understanding and calculating CIRP, investors and financial professionals can better navigate the complex world of foreign exchange markets and hedge currency risk.

For a deeper dive into the theoretical aspects and practical uses of Covered Interest Rate Parity, consider reviewing seminal texts such as “International Financial Markets” by J. Orlin Grabbe and “Multinational Business Finance” by David K. Eiteman, Arthur I. Stonehill, and Michael H. Moffett.

References:

Eiteman, D. K., Stonehill, A. I., & Moffett, M. H. (2016). Multinational Business Finance.
Grabbe, J. O. (1991). International Financial Markets.

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