Covered Interest Parity, explained.
Covered interest parity equates domestic and currency-hedged foreign investment returns in an ideal no-arbitrage benchmark.
Why it happens
One hundred domestic units earn five percent locally. Conversion at two domestic per foreign unit, two-percent foreign interest and forward conversion produce the same terminal value at F=2×1.05/1.02.
Covered interest parity equates domestic and currency-hedged foreign investment returns in an ideal no-arbitrage benchmark.
Read the result
Future spot enters the unhedged route only. The forward hedge converts the matured foreign amount at the agreed forward price.
A worked example
Remove exchange-rate uncertainty from one comparison
Keep ideal parity and the hedge on, producing domestic terminal value one hundred five through either route.
Change realised future spot and inspect the unchanged hedged foreign-route value.
Turn the hedge off so future spot matters, then distinguish exchange-rate exposure from the forward-pricing benchmark.
OPTIONAL DEEPER DETAILGo deeper: inside the model
Inside this model
One hundred domestic units earn five percent locally. Conversion at two domestic per foreign unit, two-percent foreign interest and forward conversion produce the same terminal value at F=2×1.05/1.02.
Where this idea is useful
A practical use
Recognise that an agreed forward hedge removes future spot from this particular terminal-cash calculation.
A common misconception
“The parity forward rate predicts the exchange rate that must occur later.”
The forward rate equates hedged investment routes under assumptions; it is not a guarantee about a future spot outcome.
What this explanation leaves out
- Funding access, credit, transaction costs and balance-sheet constraints are omitted. A real cross-currency basis is not automatically a freely executable arbitrage or an exchange-rate forecast.
Why might a real cross-currency basis persist?
Funding, credit, transaction and balance-sheet constraints can prevent the frictionless trades assumed by the simple parity argument.
Which future cash flow is fixed by the hedge and which remains exposed?
Associated thinkers
Associations marked provisional are awaiting source review.
Further reading
Explore the original research or the teaching reference behind this experiment.