Question

2. What is meant by covered interest parity? Are there behaviors of interest rates and exchange rates that make economists doubt covered interest parity? If so what is a convincing explanation for this.

Answer 1

Covered Interest Rate Parity Definition

What Is 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. 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 is a no-arbitrage condition that could be used in the foreign exchange markets to determine the forward foreign exchange rate. The condition also states that investors could hedge foreign exchange risk or unforeseen fluctuations in exchange rates (with forward contracts). Consequently, the foreign exchange risk is said to be covered. Interest rate parity may occur for a time, but that does not mean it will remain. Interest rates and currency rates change over time.

Example of How to Use Covered Interest Rate Parity

As an example, assume Country X's currency is trading at par with Country Z's currency, but the annual interest rate in Country X is 6% and the interest rate in country Z is 3%. 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 0.97, or 1 * ((1 + 3%) / (1 + 6%)).

Looking at the current currency market as of January 2019, we can apply the forward foreign exchange rate formula to figure out what the GBP/USD rate should be. The current spot rate for the pair is 1.32. The interest rate – using the one-year LIBOR rate – for the U.K. is 1.17% and 3.029% for the U.S. The domestic currency is the British pound, making the forward rate 1.296:

1.296=1.32 * (1 + 0.0117) / (1 + 0.03029)1.296=1.32∗(1+0.0117)/(1+0.03029)