International Finance - Uncovered and Covered Interest Rate Parity

covered interest rate parity

A condition where the difference in interest rates between two countries is exactly offset by the forward exchange rate, eliminating uncertainty using forward contracts.

uncovered interest rate parity

A condition where the expected change in exchange rates equals the difference in interest rates between two countries, without using a forward contract.

in the uncovered interest rate, If the domestic interest rate is higher (lower) than the foreign interest rate,

the domestic currency is expected to depreciate (appreciate) relative to the foreign currency.

explain cary trade

borrowing in low interest currency and invest in high interest currency hopping that the exchange rate will not change a lot to gain from it

ex.: now a lot of japanese have their savings in dollars because the Yen depreciated a lot

what is the forward premium

forward premium (discount) is the proportion by which a country’s forward exchange rate exceeds (falls below) the spot rate.

• Forward premium: HC depreciates in forward market relat to FC

• Forward discount: HC appreciates in forward market relat to FC

what is Covered Interest Rate Arbitrage

If Covered Interest Rate Parity does not hold, there would be arbitrage opportunities which can be exploited

FX swaps if covered interest rate parity holds (formula)

f = F-S/S = r - r*/(1+r*)

Covered Interest Parity and Cross-Currency Basis (formula)

b = F/S (1+r*) - (1+r)

what is the cross-currency basis

= is the difference between the interest rate implied by covered interest rate parity (CIP) and the actual market interest rate. It shows how much extra cost or gain exists when swapping one currency for another using forward contracts.

what are the drivers of the cross-currency basis

• Rise in counterparty credit risk in interbank market

• Limited market liquidity

• Large hedging demand by market participants for one of the currencies

• High funding cost of capital allocated by dealer banks to the arbitrage activity