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ECONOMICS

Covered Interest Parity  (CIP)

By: CIFER | Updated Mar 27th, 2021

Covered Interest Parity (CIP) is a financial condition that acknowledges the relationship between interest rates and the spot and forward currency valuations. The parity condition means there is no arbitrage opportunities available which typically exists when two countries have different interest rates. CIP satisfies the following condition where F and E are the forward and spot exchange rates, R and R* are domestic and foreign interest rates respectively:

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Covered Interest Arbitrage

In instances where CIP does not hold by arbitrage, risk-free profits can be made via CIA (covered interest arbitrage). This is an advanced strategy used to set up a trade whereby the trader simultaneously buys currency X while selling it forward in order to profit from the interest rate and exchange rate differentials.

 

For example: If the annual interest rates in the US and UK were 5% and 8% respectively and the current $/£ spot rate was 1.5 and the 12-month forward rate was 1.48, we can show how risk-less profits can be made.

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As this is greater than 1.0500, the value expected if the exchange rate differentials matched the interest rate differentials, it shows borrowing in the lower yielding currency and converting to the higher yielding currency would result in a risk free profit.

 

The strategy for this would look like this:

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1) Borrow $1million at 5% (USA rates)

2) Convert into GBP at $/1.5£ spot rate giving £666,667

3) Simultaneously sell future expected value £'s forward 12 months at $1.48/£ and eliminating foreign exchange risk

4)Invest in the UK money market at 8% so in 12 months time the value has increased to £720,000 (666,777 * 1.08)

5) In 12 months convert £720,000 back into USD at 1.48 giving $1,065,000

6) Repay $ loan of $1,050,000 (1,000,000 * 1.05) 

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Once USD loan is repaid, the arbitrage profit = $15,600  (1,065,000 - 1,050,000)

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Limitations of CIA

The instruments needed to benefit from inefficiencies in pricing may not be available to all investors. Access to the forward markets and to foreign money markets is not readily accessible and the effort needed to construct such a strategy may not be worthwhile. This type of strategy is best suited for large institutions who have large amounts of capital to deploy and easy access to the securities required. Lastly, once transaction costs are considered, this will likely result in little or no profits for smaller transactions.

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