Covered interest parity

What Is Covered Interest Parity?

Covered interest parity is a theoretical condition within international finance that asserts that the interest rate differential between two countries should be equal to the differential between the spot exchange rate and the forward exchange rate of their respective currencies. This concept falls under the broader category of international finance and describes a no-arbitrage equilibrium in the foreign exchange market. When covered interest parity holds, it implies that investors cannot earn a risk-free profit by borrowing in one currency, converting it, investing in a foreign asset, and simultaneously using a forward contract to hedge the exchange rate risk.

History and Origin

The foundational principle of covered interest parity (CIP) was articulated by economist John Maynard Keynes in 1923, during a period of floating exchange rates following World War I. Keynes posited that the forward premium or discount on an exchange rate should precisely offset any difference in nominal interest rates between two currencies. This concept served as a fundamental building block in the understanding of international capital flows and the pricing of currency derivatives. For decades, until the Global Financial Crisis, covered interest parity largely held, functioning as a robust relationship in global financial markets⁵.

Key Takeaways

• Covered interest parity is a theoretical no-arbitrage condition linking spot and forward exchange rates with interest rate differentials between two currencies.
• It implies that the return on a hedged foreign investment should equal the return on a domestic investment.
• The condition relies on the assumption of free capital mobility and the absence of transaction costs or other market frictions.
• Deviations from covered interest parity can indicate market inefficiencies or the presence of financial market frictions.
• This concept is crucial for understanding currency hedging strategies and international investment returns.

Formula and Calculation

Covered interest parity can be expressed by the following formula:

$(1 + i_d) = \frac{S}{F} (1 + i_f)$

Where:

• ( i_d ) = Domestic interest rate
• ( i_f ) = Foreign interest rate
• ( S ) = Spot exchange rate (domestic currency per unit of foreign currency)
• ( F ) = Forward exchange rate (domestic currency per unit of foreign currency)

Rearranging the formula to solve for the forward rate (which is often implied by CIP), we get:

$F = S \times \frac{(1 + i_f)}{(1 + i_d)}$

This formula demonstrates the relationship where the ratio of the spot exchange rate to the forward exchange rate must be equivalent to the ratio of the domestic interest rate factor to the foreign interest rate factor for parity to hold.

Interpreting the Covered Interest Parity

When covered interest parity holds, it means there is no opportunity for a financial professional to execute a risk-free arbitrage strategy by exploiting interest rate differentials across two currencies, combined with the current spot and forward exchange rates. This equilibrium suggests that the cost of borrowing in one currency, converting it, investing in another, and then covering the foreign exchange exposure through a forward contract, yields the same return as simply investing in the domestic currency. If the parity condition does not hold, an opportunity for covered interest arbitrage exists, allowing an investor to earn a profit with virtually no risk. This typically occurs through movements in the forward exchange rate to re-establish the equilibrium, assuming financial market efficiency.

Hypothetical Example

Consider an investor in the United States looking at investment opportunities in both the U.S. dollar (USD) and the Euro (EUR).

• U.S. Data:
  • U.S. interest rate ((i_d)): 2.0% per annum
• Eurozone Data:
  • Eurozone interest rate ((i_f)): 1.0% per annum
• Exchange Rates:
  • Spot exchange rate (S) (USD/EUR): 1.10 USD per EUR
  • Forward exchange rate (F) for one year (USD/EUR): 1.11 USD per EUR

To check for covered interest parity, we compare two scenarios for a $1,000 investment:

Scenario 1: Invest domestically in the U.S.
If the investor puts $1,000 in a U.S. deposit, after one year, the return would be:
( $1,000 \times (1 + 0.02) = $1,020 )

Scenario 2: Invest in the Eurozone, covered by a forward contract

1. Convert $1,000 to EUR at the spot rate: ( $1,000 / 1.10 = 909.09 ) EUR
2. Invest 909.09 EUR in a Eurozone deposit: ( 909.09 \times (1 + 0.01) = 918.18 ) EUR after one year.
3. Simultaneously, enter a forward contract to sell 918.18 EUR in one year at the forward rate of 1.11 USD/EUR to convert back to USD: ( 918.18 \times 1.11 = $1,019.18 )

In this hypothetical example, the return from investing domestically ($1,020) is very close to, but slightly higher than, the return from the covered foreign investment ($1,019.18). This small discrepancy could indicate a minor arbitrage opportunity or simply reflect real-world transaction costs not included in the simplified example. If the returns were exactly equal, covered interest parity would hold.

Practical Applications

Covered interest parity is a fundamental concept in global financial markets with several practical applications:

• Forward Exchange Rate Determination: The CIP formula is often used by financial institutions to price forward exchange rate contracts. By observing domestic and foreign interest rates and the spot rate, traders can determine the theoretical no-arbitrage forward rate.
• Currency Hedging Strategies: Multinational corporations and investors use forward contracts to hedge against foreign exchange risk when making international investments. Covered interest parity underpins the cost and effectiveness of such hedging strategies, ensuring that the benefit of higher foreign interest rates is offset by the cost of hedging.
• Arbitrage Opportunities: While theoretically eliminating arbitrage, persistent deviations from covered interest parity can signal profitable opportunities for sophisticated traders to exploit discrepancies between interest rates and forward premiums or discounts.
• Monetary Policy Insights: Deviations from covered interest parity can also offer insights into the effectiveness of monetary policy and liquidity conditions in different money market segments. Central banks, like the European Central Bank, have observed how CIP deviations can reflect market frictions and influence international funding costs⁴.

Limitations and Criticisms

While covered interest parity is a cornerstone of international finance theory, real-world observations often reveal deviations, especially since the 2008 Global Financial Crisis. These deviations suggest that the strict assumptions of the theory, such as perfect capital mobility and zero transaction costs, do not always hold.

Key limitations and criticisms include:

• Financial Frictions and Regulatory Changes: Post-crisis, increased bank capital regulations and liquidity requirements have made it more costly for financial intermediaries to conduct the arbitrage necessary to enforce covered interest parity. This has led to persistent deviations, particularly in the cross-currency basis swap market, as the cost of borrowing one currency synthetically via another has become more expensive than direct borrowing³.
• Credit Risk and Counterparty Risk: The theory typically assumes no credit or counterparty risk. In reality, the risk of default by a counterparty in a forward contract or a bank deposit can lead to deviations from parity.
• Liquidity Constraints: Even if arbitrage opportunities exist, the availability of sufficient capital for arbitrageurs or liquidity in specific market segments can be limited, preventing the full equalization of returns. Research from the Federal Reserve has explored how bank regulation and monetary policy influence these deviations by affecting the supply and demand for currencies in foreign exchange swap markets².
• Market Segmentation: Global financial markets are not perfectly integrated. Different types of investors and institutions face varying funding costs and regulatory environments, leading to segmented markets where covered interest parity may not hold uniformly.

These factors can lead to what is known as the "CIP puzzle," where seemingly risk-free financial instruments do not yield identical returns, prompting ongoing research into the causes and implications of these persistent deviations.

Covered Interest Parity vs. Uncovered Interest Parity

Covered interest parity (CIP) and uncovered interest parity (UIP) are two fundamental concepts in international finance that relate exchange rates and interest rates, but they differ significantly in their treatment of foreign exchange risk.

Covered interest parity (CIP) describes a no-arbitrage condition where investors use a forward exchange rate to fully eliminate, or "cover," the risk of unfavorable movements in the exchange rate when investing in a foreign currency. It implies that a hedged investment in a foreign asset should yield the same return as a domestic investment. The forward rate is known and locked in at the time of the transaction, making the arbitrage profit risk-free if the condition does not hold.

In contrast, uncovered interest parity (UIP) is an equilibrium condition that does not involve hedging the exchange rate risk with a forward contract. Instead, it posits that the expected change in the spot exchange rate over the investment horizon should offset any interest rate differential. This means that an unhedged foreign investment is expected to yield the same return as a domestic investment, but this expectation is subject to the uncertainty of future spot exchange rates. UIP assumes risk neutrality among investors and relies on the idea that expected returns, not actual returns, are equalized. Due to its reliance on expectations, UIP tends to hold less consistently in practice compared to CIP, which generally holds quite well, especially for major currencies in liquid markets, before accounting for recent market frictions.

FAQs

Q: What is the primary purpose of covered interest parity?
A: The primary purpose of covered interest parity is to describe a theoretical equilibrium where there are no risk-free arbitrage opportunities by exploiting differences in interest rates and exchange rates when using a forward contract to cover foreign exchange risk.

Q: Why do deviations from covered interest parity occur?
A: Deviations from covered interest parity often occur due to real-world financial frictions not accounted for in the theoretical model. These include transaction costs, limits to arbitrage capital, credit risk, counterparty risk, and post-crisis regulatory changes that have increased the cost of balance sheet usage for banks¹.

Q: How does covered interest parity relate to hedging?
A: Covered interest parity is directly related to hedging because it examines a scenario where an investor uses a forward exchange rate to "cover" or eliminate the foreign exchange risk associated with a foreign investment. This allows for a direct comparison of risk-free returns between domestic and foreign assets.

Q: Is covered interest parity always true in the real world?
A: No, while covered interest parity generally held true for many decades, especially for major currency pairs, it has experienced significant and persistent deviations since the 2008 Global Financial Crisis. These deviations highlight market imperfections and structural changes in global money market liquidity and regulation.