Covered Interest Rate Parity

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DEFINITION of 'Covered Interest Rate Parity'

This term refers to a condition where the relationship between interest rates and the spot and forward currency values of two countries are in equilibrium. As a result, there are no interest rate arbitrage opportunities between those two currencies.

BREAKING DOWN 'Covered Interest Rate Parity'

As an example, assume Country X's currency is trading at par with Country Z's currency, but the interest rate in Country X is 6% and the interest rate in country Z is 3%. All other things being equal, it would make good 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, in order 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 transaction.

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RELATED FAQS
  1. How do companies benefit from interest rate and currency swaps?

    An interest rate swap involves the exchange of cash flows between two parties based on interest payments for a particular ... Read Full Answer >>
  2. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  3. Over what time period should I be looking at the forward rate?

    Your target time horizon for forward rates depend on your own investment horizon. If you have a specific forward contract, ... Read Full Answer >>
  4. What kinds of derivatives are types of forward commitments?

    A derivative is a type of security in which the price of the security is dependent on underlying assets. A derivative could ... Read Full Answer >>
  5. How do I calculate a forward rate in Excel?

    You need to have the zero-coupon yield curve information to calculate forward rates, even in Microsoft Excel. Once the spot ... Read Full Answer >>
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