What is Covered Interest Rate Parity (CIRP)?
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. The covered interest rate parity situation means there is no opportunity for arbitrage using forward contracts, which often exists between countries with different interest rates.
Covered interest rate parity (CIP) can be compared with uncovered interest rate parity (UIP).
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.
Assumptions of Covered interest rate parity
- Non-arbitrage condition: CIRP puts into effect a no-arbitrage condition that eliminates all potential opportunities to make risk-free profits across international financial markets.
- Homogeneity of assets: CIRP assumes that two assets are identical in every respect except for their currency of denomination.
- Interest rate differential = 0: CIRP works under the assumption that the interest rate differential of two assets in the forward market should be continuously equal to zero.
Limitations of Using Covered Interest Rate Parity
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.
Example of Covered Interest Rate Parity
For example, say Country A’s currency is being traded at par with Country B’s currency, but the interest rate in Country A is 8%, and the interest rate in country B is 6%. Hence, an investor would see it beneficial to borrow in B’s currency, convert it to A’s currency in the spot market and then reconvert the investment proceeds back into currency B.
However, to repay the loan taken in currency B, the investor will need to enter into a forward contract to convert the currency from A to B. Covered interest rate parity comes into the picture when the forward rate being used to convert the currency from A to B eliminates all potential profits from the transaction, and removes the opportunity of risk-free profits, and puts the non-arbitrage condition in place.
Finally, we are now aware that the CIRP has certain unrealistic assumptions that might not hold true, and therefore the forward rates may be misquoted in the market, and there could be an arbitrage opportunity.
There is a counterintuitive assumption underlying the appreciation and depreciation of the two currencies involved to offset the effect of the difference in the interest rates, which may not always occur.