What is Covered Interest Rate Parity
Covered interest rate parity refers to a theoretical condition in which the relationship between interest rates and the spot and forward currency values of two countries are in equilibrium. The covered interest rate parity situation means there is no opportunity for arbitrage using forward contracts, which often exists between countries with different interest rates.
Breaking Down 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. Consequently, the foreign exchange risk is said to be covered.
Interest rate parity may occur for a time, but that does not mean it will remain. Interest rates and currency rates change over time.
Covered Interest Rate Parity Formula
Under the covered interest rate parity, the following formula must hold true, otherwise, there would be an arbitrage opportunity: (1 + id) = (S / F) * (1 + if).
The formula above can be rearranged to determine the forward foreign exchange rate, in which F = S * ((1 + if) / (1 + id)).
id is the interest rate in the domestic currency or the base currency.
if is the interest rate in the foreign currency or the quoted currency.
S is the current spot foreign exchange rate.
F is the forward foreign exchange rate.
Under normal circumstances, a currency that offers lower interest rates tends to trade at a forward foreign exchange rate premium in relation to another currency offering higher interest rates.
Covered Interest Rate Parity Example
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 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, 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.
Since the currencies are trading at par, one unit of Country X's currency is equivalent to one unit of Country Z's currency. Assume that the domestic currency is Country Z's currency. Therefore, the forward price is equivalent to 0.97, or 1 * (1 + 3%) / (1 + 6%).