Interest rates and currency rates change over time. All other things being equal, it would make sense to borrow in the currency of Z, convert it in the spot market to currency X, and invest the proceeds in Country X. However, to repay the loan in currency Z, one must enter into a forward contract to exchange the currency back from X to Z. Covered interest rate parity exists when the forward rate of converting X to Z eradicates all the profit from the transaction.
Since the currencies are trading at par, one unit of Country X's currency is equivalent to one unit of Country Z's currency.
Assume that the domestic currency is Country Z's currency. Therefore, the forward price is equivalent to 0. Looking at the currency market in Dec. The spot rate for the pair was 1. The domestic currency is the British pound, making the forward rate 1. Covered interest parity involves using forward contracts to cover the exchange rate. Meanwhile, uncovered interest rate parity involves forecasting rates and not covering exposure to foreign exchange risk — that is, there are no forward rate contracts, and it uses only the expected spot rate.
There is no difference between covered and uncovered interest rate parity when the forward and expected spot rates are the same. Interest rate parity says there is no opportunity for interest rate arbitrage for investors of two different countries. But this requires perfect substitutability and the free flow of capital. Sometimes there are arbitrage opportunities. This comes when the borrowing and lending rates are different, allowing investors to capture riskless yield.
For example, the covered interest rate parity fell apart during the financial crisis. However, the effort involved to capture this yield usually makes it non-advantageous to pursue. Advanced Forex Trading Concepts. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.
These choices will be signaled globally to our partners and will not affect browsing data. We and our partners process data to: Actively scan device characteristics for identification. I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Key Takeaways The covered interest rate parity condition says that the relationship between interest rates and spot and forward currency values of two countries are in equilibrium.
It assumes no opportunity for arbitrage using forward contracts. Covered and uncovered interest rate parity are the same when forward and expected spot rates are the same. Article Sources. Investopedia requires writers to use primary sources to support their work. In general, a currency with a lower interest rate will trade at a forward premium to a currency with a higher interest rate.
As can be seen in the above example, X and Y are trading at parity in the spot market, but in the one-year forward market, each unit of X fetches 1. Covered interest arbitrage in this case would only be possible if the cost of hedging is less than the interest rate differential. A savvy investor could therefore exploit this arbitrage opportunity as follows:.
Interest Rates. Advanced Forex Trading Concepts. Investing Essentials. Metals Trading. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page. These choices will be signaled globally to our partners and will not affect browsing data.
We and our partners process data to: Actively scan device characteristics for identification. I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. What Is Covered Interest Arbitrage? Key Takeaways Covered interest arbitrage uses a strategy of arbitraging the interest rate differentials between spot and forward contract markets in order to hedge interest rate risk in currency markets.
This form of arbitrage is complex and offers low returns on a per-trade basis. But trade volumes have the potential to inflate returns. These opportunities are based on the principle of covered interest rate parity. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.
Forex Spot Rate The forex spot rate is the most commonly quoted forex rate in both the wholesale and retail market. Understanding Covered Interest Rate Parity Covered interest rate parity refers to a theoretical condition in which the relationship between interest rates and the spot and forward currency values of two countries are in equilibrium. Understanding Uncovered Interest Rate Parity — UIP Uncovered interest rate parity UIP states that the difference in two countries' interest rates is equal to the expected changes between the two countries' currency exchange rates.
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