Covered Interest Parity

Published Apr 7, 2024

Definition of Covered Interest Parity

Covered Interest Parity (CIP) is a financial theory that states the relationship between interest rates and the foreign exchange market is such that arbitrage opportunities are eliminated due to forward exchange contracts. According to CIP, the difference in interest rates between two countries is equal to the difference between the spot and forward exchange rates of their currencies. This theory ensures that investors cannot achieve higher returns on their investments by exploiting differences in interest rates between countries when they cover their exchange rate risk with forward contracts.

Example

Imagine an American investor is considering investing in bonds in either the United States or the United Kingdom. The annual interest rate for the US bond is 2%, and for the UK bond, it’s 4%. At first glance, the UK bond seems more attractive. However, to make an accurate comparison, the investor also needs to consider the exchange rate risk.

Assume the current exchange rate (spot rate) is $1.3 per pound, and the forward rate for a one-year contract is $1.28 per pound. The investor can use a forward contract to lock in the exchange rate at $1.28 per pound for converting the UK investment back to dollars in one year.

By calculating the returns considering both the interest rates and exchange rate changes, the investor may find that the potential higher returns from the UK bond (due to its higher interest rate) could be offset by the expected depreciation of the pound against the dollar, represented by the difference between the spot and the forward exchange rate. Hence, when the interest rate differential is balanced by the currency exchange risk, as covered by the forward contract, the investor is indifferent between investing domestically or overseas. This state of indifference showcases the principle of Covered Interest Parity in action.

Why Covered Interest Parity Matters

Covered Interest Parity is pivotal for international financial management and economics for several reasons. First, it forms the foundation for making decisions regarding foreign investments and understanding the relationship between exchange rates and interest rates. For financiers, accurately predicting movements in these rates can significantly impact investment decisions and hedging strategies.

Additionally, CIP helps maintain efficiency within the forex markets by removing arbitrage opportunities. If CIP did not hold, arbitrators could exploit the difference in interest rates and forward exchange rates for risk-free profits, which could cause distortions in the financial markets. Thus, CIP contributes to market stability by ensuring that no such opportunities persist.

Finally, CIP is essential for policymakers and economists as it is used to assess market conditions and the effectiveness of monetary and fiscal policies on a global scale. Deviations from CIP may indicate market inefficiencies, barriers to capital flows, or risks perceived by investors that could warrant closer examination.

Frequently Asked Questions (FAQ)

Under what circumstances can Covered Interest Parity fail?

While CIP is a fundamental principle in finance, there are circumstances under which it can fail. For instance, during financial crises, when liquidity is low, and risk aversion is high, investors might prioritize safety over arbitrage, leading to deviations from CIP. Additionally, transaction costs and capital controls imposed by some countries can prevent arbitrageurs from taking advantage of potential disparities between interest rates and exchange rates, hence breaking the CIP condition.

How does CIP differ from Uncovered Interest Parity?

Uncovered Interest Parity (UIP) is similar to CIP in examining the relationship between interest rates and exchange rates. However, unlike CIP, UIP does not involve the use of forward contracts to hedge against exchange rate risk. Instead, UIP assumes that investors are compensated for exchange rate risk through the difference in interest rates alone. This means that while CIP is concerned with risk-free arbitrage opportunities, UIP deals with expected returns, making it more speculative and subject to currency risk.

What role do forward contracts play in achieving Covered Interest Parity?

Forward contracts are instrumental in achieving CIP as they allow investors to lock in an exchange rate today for a transaction that will occur in the future. By using forward contracts to hedge against future changes in exchange rates, investors can neutralize the currency risk associated with international investments. This ensures that any discrepancies between domestic and foreign interest rates are precisely offset by the costs or gains from the forward contract, thus eliminating the potential for arbitrage and bringing the market into a state of covered interest parity.