Updated July 10, 2023
Definition of Covered Interest Rate Parity
Interest Rates and currency rates vary for different countries depending upon whether they are developed, developing, or underdeveloped. In fact, within a category, these rates vary depending upon the growth of individual nations.
Covered Interest Rate Parity is an economic theory that states that the difference in interest rates of two nations is offset by the difference in spot and forward rates of currency among the two nations, thereby ensuring that the cost of direct borrowing from one nation and synthetic borrowing from another nation and converting into the currency of the first nation result in the same cost, leaving no risk free arbitrage opportunity to exploit on account of interest differential between two nations.
Explanation
Covered Interest Parity holds the convention of No arbitrage. It is the antonym for Covered Interest Arbitrage. Covered interest Parity helps determine the forward exchange rate as it considers the differential interest rates and helps determine the discount or premium to the forward exchange rate to ensure no arbitrage opportunity exists.
In the absence of a Covered Interest Parity, one can borrow at low interest and lend at higher interest, thereby earning risk-free profit. To plug this gap and to ensure no risk-free arbitrage opportunity remains, covered interest rate parity theory states that the exchange rate offsets the differential in interest rates among the low-interest rate nation ( usually a developed nation) and high-interest rate nation ( usually a Developing Nation or an Under Developed nation).
The formula of Covered Interest Rate Parity:
Covered Interest Rate Parity can be denoted with the following formula as enumerated below:
Where Forward DC/FC is the forward exchange rate
- Spot DC/FC is the spot exchange rate
- RDOMESTIC is the interest rates in domestic currency
- RFOREIGNis the interest rates in foreign currency
Example of Covered Interest Rate Parity
Let us understand its concept with the help of a numerical example.
The domestic interest rates in Country A, a developing nation, are 9%and the domestic interest rates in foreign currency in Country B, a developed nation, are 7%.
The current spot rate is 4.908%. To have covered Interest rate parity, the forward exchange rate should be such that it equates to the equation per the formula described above. Based on the inputs provided, the derived Forward exchange rate turns out to be 5.00, which will make the two sides equal, as shown below:
Forward DC/FC/ Spot DC/FC = (1 + RDOMESTIC) / (1 + RFOREIGN)
- Forward DC/FC = (1 + RDOMESTIC) / (1 + RFOREIGN)/ Spot DC/FC
- Forward DC/FC = (1 + RDOMESTIC)* Spot DC/FC / (1 + RFOREIGN)
- Forward DC/FC = (1+9%)*4.908/ (1+7%)
- Forward DC/FC = 5.00
Thus with a forward exchange rate of 5, the covered interest rate parity financial conditions hold. Any rate below or above this will lead to arbitrage opportunities.
Assumptions of Covered Interest Rate Parity
The biggest assumption is the free movement of capital and no restriction on borrowing and lending of funds across different nations, which is not the case in the practical world.
Secondly, the risk level varies from nation to nation based on the overall country risk and economic outlook, which are not taken into consideration by the Covered Interest Rate Parity as it assumes that an investor will be indifferent to obtaining an asset in one country with the same risk, liquidity, and volatility as it acquires in another country which may not be the case in the real world.
Covered Rate Interest Parity is based on the premise that no arbitrage opportunities arise due to interest rate differential between two jurisdictions. Any arbitrage arising during the financial crisis is short-lived, and parity returns once the event is settled.
Importance of Covered Interest Rate Parity
It holds a lot of importance. Its importance can be highlighted by the following benefits that it offers, namely;
- It helps determine the forward exchange rate movements, enabling market participants to analyze currency movements.
- It helps exploit arbitrage opportunities as and when they arise and keeps markets in equilibrium.
- It helps understand how exchange rates are determined and what factors impact them most.
Advantages
It offers multiple advantages. A few noteworthy are enumerated below:
- First, it avoids arbitrage trades by allowing parity across different currencies and interest rates, discouraging excess speculation.
- It helps keep a balancing act between the currency rates and cross interest rates.
- It helps predict the forward rate and likely movement of interest rates and is used frequently by Economists and Macro Analysts in conjunction with other economic and financial theories.
Disadvantages
Despite the multiple advantages, there are certain disadvantages, as enumerated below:
- The financial theory lacks practical application, and it has often been observed that arbitrage exists.
- It is observed that during stress periods, especially during subprime crises and recent pandemic crises, the theory doesn’t hold.
- It doesn’t consider that it also affects the interest differential and is not accounted for in the exchange rates of the two nations.
Conclusion
It is an important economic metric used to measure interest rates and currency movements across different countries and ensure arbitrage opportunities are kept in check by the Financial and Investment community. It is based on the premise that interest rates and currency movement move so that market participants can exploit no arbitrage opportunities.
Despite being such a popular economic theory, it is too difficult to hold good in the real world which is because counterparty risk varies across different nations, and heightened exchange rate regulation through active involvement of local governments results in a deviation from the basic premise of which this economic theory is based upon.
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