Covered Interest Rate Parity (CIRP)

Covered interest rate parity (CIRP) is a no-arbitrage condition linking interest rates, spot exchange rates, and forward exchange rates between two currencies. It states that after hedging foreign-exchange exposure with a forward contract, investors cannot earn a riskless profit by borrowing in one currency and investing in another.

Key takeaways

• CIRP ensures equilibrium between spot and forward exchange rates given the two countries’ interest rates, eliminating arbitrage.
• Forward contracts are used to hedge currency risk, hence the term “covered.”
• If CIRP holds, any potential gain from interest-rate differentials is offset by the forward exchange rate.
• CIRP can break down in practice when markets are imperfect (transaction costs, capital controls, funding constraints), particularly during financial stress.

Formula

The forward rate is given by:
F = S × (1 + i_d) / (1 + i_f)

where:
* F = forward exchange rate
* S = current spot exchange rate (quoted as units of foreign currency per unit of domestic/base currency)
* i_d = interest rate in the domestic (base) currency
* i_f = interest rate in the foreign (quoted) currency

Interpretation: if the domestic interest rate is higher than the foreign rate, the domestic currency will typically trade at a forward discount (or the quoted rate will adjust) so that covered arbitrage yields no profit.

How CIRP works (arbitrage logic)

1. Borrow in the lower-interest currency.
2. Convert the proceeds at the spot rate to the higher-interest currency and invest.
3. Enter a forward contract to convert the invested proceeds back into the borrowing currency at maturity.
4. If CIRP holds, the forward rate will be such that the net return after repaying the original loan equals the domestic return, leaving no arbitrage profit.

Examples

Example 1 — Simple parity:
– Two currencies trade at par (1:1). Country X interest = 6%, Country Z interest = 3%.
– Borrow in Z (3%), convert to X, invest at 6%, and lock in the forward to repay Z.
– Forward rate from X to Z that eliminates profit: F = 1 × (1 + 3%) / (1 + 6%) = 0.970.

Example 2 — GBP/USD:
– Spot GBP/USD = 1.35 (1 GBP = 1.35 USD).
– U.K. (domestic) interest i_d = 3.25%, U.S. (foreign) interest i_f = 1.10%.
– Forward GBP/USD = 1.35 × (1 + 0.0325) / (1 + 0.011) ≈ 1.38.
This forward rate offsets the interest differential so covered arbitrage is neutral.

Covered vs. Uncovered Interest Rate Parity

• Covered interest rate parity (CIRP): uses forward contracts to lock the exchange rate and eliminate FX risk.
• Uncovered interest rate parity (UIP): links expected future spot rates to interest-rate differentials without hedging; it relies on expectations and carries exchange-rate risk.
  If the forward rate equals the expected future spot rate, CIRP and UIP imply the same relationship; in practice they often differ.

Limitations and when CIRP may fail

CIRP is a theoretical condition that assumes:
* No transaction costs or bid–ask spreads
* Free and frictionless capital movement
* Ability to borrow/lend at the quoted rates

Real-world frictions that can break CIRP:
* Transaction costs, bid–ask spreads, and margin requirements
* Capital controls or regulatory constraints
* Funding constraints and counterparty risk (notably during crises)
* Large cross-currency basis swaps and deviations in interbank funding markets

CIRP notably showed breakdowns during the Global Financial Crisis and other stress periods, creating measurable cross-currency bases and arbitrage opportunities that were costly or impractical to exploit.

Quick FAQs

Q: What does “covered” mean here?
A: It means exchange-rate exposure is hedged with a forward (or futures) contract.

Q: Are covered arbitrage opportunities common?
A: No. When they appear, exploiting them is often limited by costs, funding issues, or counterparty constraints.

Q: Which rate appears in the numerator of the formula?
A: The domestic (base) currency interest rate appears in the numerator: F = S × (1 + i_d)/(1 + i_f), where S is quoted as foreign currency per unit of domestic currency.

Bottom line

Covered interest rate parity provides a clear no-arbitrage link between interest-rate differentials and forward exchange rates when markets are efficient and frictionless. It is a useful benchmark for pricing forwards and understanding how interest rates and FX markets interact, but real-world frictions and stress events can produce durable deviations.