Question

Explain the relationship between the spot exchange rate and the forward exchange rate using the covered interest parity (CIP) formula.

Answer 1

In forex market each country has different borrowing or landing rate . There can be situation where personal can borrow in currency of a country having lower rate of interest and can sale in spot market for other country currency having higher rate of interest. Sale proceed (in other currency) can be invested or used for landing to earn higher return for specific preiod and risk less profit can be earned by entering into forward contract in currency market . Above transaction is called arbitrage opportunity.

Covered interest parity state that there is no such arbitrage opportunity exit and forward rate will take into account this interest rate difference between two countires in such manner that profit earned due to differece in interest rate will offset by losses in forward contract.

As per covered interest parity below is the formula for forward rate =

F = S *(1+if)/(1+id)

F= foward rate

S = Spot rate

If= interest rate prevailing at foregin country

id= interest rate prevailing at domestic country.