A theoretical financial condition that defines the relationship between interest rates and the spot and forward currency rates of two countries
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Covered interest rate parity (CIRP) is a theoretical financial condition that defines the relationship between interest rates and the spot and forward currency rates of two countries. It establishes the fact that there is no opportunity for arbitrage using forward contracts, which are often used to make loose profits by exploiting the difference in interest rates. It holds that the difference in interest rates should equal the forward and spot exchange rates.
Covered interest rate parity (CIRP) is a theoretical financial condition that defines the relationship between interest rates and the spot and forward currency rates of two countries.
CIRP holds that the difference in interest rates should equal the forward and spot exchange rates.
Without interest rate parity, it would be very easy for banks and investors to exploit differences in currency rates and make loose profits.
Formula for Covered Interest Rate Parity
Covered interest rate parity can be conceptualized using the following formula:
espot is the spot exchange rate between the two currencies
eforwardis the forward exchange rate between the two currencies
iDomesticis the domestic nominal interest rate
iForeignis the foreign nominal interest rate
Assumptions of CIRP
Non-arbitrage condition: CIRP puts into effect a no-arbitrage condition that eliminates all potential opportunities to make risk-free profits across international financial markets.
Homogeneity of assets: CIRP assumes that two assets are identical in every respect except for their currency of denomination.
Interest rate differential = 0: CIRP works under the assumption that the interest rate differential of two assets in the forward market should be continuously equal to zero.
Example of CIRP
For example, say Country A’s currency is being traded at parwith Country B’s currency, but the interest rate in Country A is 8%, and the interest rate in country B is 6%. Hence, an investor would see it beneficial to borrow in B’s currency, convert it to A’s currency in the spot market and then reconvert the investment proceeds back into currency B.
However, to repay the loan taken in currency B, the investor will need to enter into a forward contract to convert the currency from A to B. Covered interest rate parity comes into the picture when the forward rate being used to convert the currency from A to B eliminates all potential profits from the transaction, and removes the opportunity of risk-free profits, and puts the non-arbitrage condition in place.
Covered Interest Rate Parity vs. Uncovered Interest Rate Parity
1. Future rates
Covered interest rate parity involves the use of future rates or forward rates when assessing exchange rates, which also makes potential hedging possible. However, uncovered interest rate parity takes into account the expected rates, which basically implies forecasting future interest rates. Hence, it involves the use of an estimation of the expected future rate and not the actual forward rate.
2. Difference in exchange rates
According to covered interest rate parity, the difference between interest rates gets adjusted in the forward discount/premium. When investors borrow from a lower interest rate currency and invest in a higher interest rate currency, they are consequently in advantage through a forward cover.
The forward cover eliminates any risks associated with the investment. However, the uncovered interest for parity adjusts the difference between interest rates by equating the difference to the domestic currency’s expected rate of depreciation. It is because, in an uncovered interest rate parity condition, investors do not benefit from any forward cover.
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