Covered Interest Rate Parity

Definition

Covered interest rate parity is an economic theory that describes the relationship between interest rates and currency exchange rates, ensuring that there are no arbitrage opportunities in the foreign exchange market when forward contracts are utilized. It indicates that the difference in interest rates between two countries is equal to the differential between the forward exchange rate and the spot exchange rate, meaning that investors should be indifferent between investing domestically or abroad when taking into account hedging against exchange rate risk.

5 Must Know Facts For Your Next Test

1. Covered interest rate parity holds only when transaction costs are negligible, and markets are efficient, allowing for perfect arbitrage opportunities.
2. If covered interest rate parity is violated, investors can earn risk-free profits through arbitrage by borrowing in a currency with a lower interest rate and investing in one with a higher rate while covering their exchange rate risk.
3. The concept relies on the assumption that capital can move freely across borders without restrictions, ensuring equal returns on investments in different currencies.
4. Covered interest rate parity is used by investors and institutions to assess the pricing of forward contracts and make informed decisions about international investments.
5. In practical terms, covered interest rate parity helps maintain equilibrium in the foreign exchange market, as deviations from this condition prompt market participants to act until parity is restored.

Review Questions

• How does covered interest rate parity ensure that investors do not face arbitrage opportunities when trading currencies?
  • Covered interest rate parity ensures that investors do not face arbitrage opportunities by aligning the differences in interest rates with forward and spot exchange rates. When the forward exchange rate reflects the interest rate differential, it eliminates the possibility of risk-free profits from borrowing in one currency and investing in another. If a disparity occurs, investors will quickly engage in arbitrage, buying and selling currencies until equilibrium is restored.
• Discuss the implications of a violation of covered interest rate parity on foreign investment strategies.
  • A violation of covered interest rate parity has significant implications for foreign investment strategies as it indicates potential profit opportunities through arbitrage. Investors may respond by borrowing in a currency with lower interest rates and investing in higher-yielding currencies while hedging their exchange risk. This can lead to increased capital flows into certain markets, potentially causing fluctuations in currency values and altering overall investment patterns based on perceived risks and returns.
• Evaluate how covered interest rate parity contributes to the efficiency of global financial markets and the pricing of financial instruments.
  • Covered interest rate parity plays a crucial role in enhancing the efficiency of global financial markets by ensuring that there are no unexplained price discrepancies between currencies. By linking interest rates to forward and spot rates, it establishes a framework for pricing financial instruments such as forward contracts. This relationship helps to stabilize expectations among investors regarding future currency values, thereby reducing uncertainty and promoting informed decision-making in international finance.

Related terms

Arbitrage: The practice of taking advantage of price differences in different markets by buying low and selling high simultaneously.

Forward Exchange Rate: The agreed-upon exchange rate for a currency transaction that will occur at a future date, allowing investors to lock in prices and hedge against currency risk.

Spot Exchange Rate: The current market price at which a currency can be exchanged for another currency immediately.