Covered Interest Rate Parity
Candlefocus EditorThe concept of covered interest rate parity (CIP) states that the difference between the forward and spot exchange rate of two currencies should be equal to the difference between the interest rates of two countries. This means that the forward exchange rate should equal the expected future spot rate plus or minus the interest rate differential between the two countries, depending on the direction of the spot rate’s change.
For example, if the prevailing interest rate in the US is 3%, and the prevailing interest rate in the UK is 5%, then the forward exchange rate should be equal to the expected future spot rate plus 2%. If the US dollar is expected to appreciate, then the forward US dollar rate should be greater than the expected future spot rate, by the amount of the interest rate differential between the two countries.
On the other hand, if the US dollar is expected to depreciate, then the forward US dollar rate should be lower than the expected future spot rate, by the amount of the interest rate differential between the two countries. In this way, CIP allows investors to hedge their risk when transacting across currencies, by requiring them to consider both the spot and forward exchange rates when setting their rates.
Covered interest rate parity is a theoretical concept that holds true in perfect market conditions. However, in practice, this parity can be disrupted by a number of factors including transaction costs and liquidity issues. Moreover, it is important to remember that the exchange rate parity only holds when the two currencies are not subject to government intervention. In such cases, the markets are more likely to experience temporary deviations from CIP, as market forces seek to restore a sense of balance.
In conclusion, it can be seen that Covered Interest Rate Parity is a fundamental economic concept that is essential to efficient currency exchange and risk hedging strategies. By taking into account the impact of interest rates on spot and forward exchange rates, this parity condition provides investors with an opportunity to hedge their risk when investing in foreign currencies. In practice, however, deviations from CIP are to be expected, as factors such as transaction costs and government intervention can disrupt the parity condition.