What covered interest rate parity (CIP) is — short definition
– Covered interest rate parity is a no‑arbitrage relationship that links the current (spot) exchange rate, the forward exchange rate, and the interest rates in two currencies. If CIP holds, an investor cannot earn a riskless profit by borrowing in one currency, converting to another currency, investing at the other currency’s interest rate, and using a forward contract to lock in the future exchange rate for repaying the original loan.
Key terms (brief)
– Spot rate: the current price to exchange one currency for another.
– Forward rate: an agreed exchange rate today for exchanging currencies at a specified future date.
– Forward contract: an agreement to exchange currencies at a set future rate (used to “cover” or hedge FX risk).
– Arbitrage: a risk‑free profit created by price differences between markets or instruments.
– Covered vs. uncovered parity: “covered” uses a forward contract to eliminate FX risk; “uncovered” relies on the expected future spot rate and leaves FX risk open.
The formula (one clear version)
– If S is the current spot price (price of one unit of foreign currency in domestic currency terms), id is the domestic interest rate, and if is the foreign interest rate, the theoretical forward rate F that removes arbitrage is:
F = S × (1 + id) / (1 + if)
– Interpretation: the forward price adjusts the spot price in proportion to the relative returns available from domestic versus foreign interest rates.
Why it matters
– CIP is the foundation for pricing forward FX contracts and interbank FX‑swap markets. When CIP holds, covered arbitrage does not exist. Deviations from CIP indicate funding frictions, counterparty risk, capital controls, or other market frictions and are visible in the cross‑currency basis (the extra cost to swap currencies).
Worked numeric examples (step‑by‑step)
Example A — Simple two‑country illustration
– Setup: Two currencies trade at parity today: 1 unit of X = 1 unit of Z (so S = 1.00). Interest rate in country X = 6% (iX = 0.06). Interest rate in country Z = 3% (iZ = 0.03). Domestic currency = Z.
– Formula with domestic = Z and foreign = X: F = S × (1 + id) / (1 + if) = 1.00 × (1 + 0.03)/(1 + 0.06).
– Calculation: F =