Covered Interest Rate Parity

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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