Definition
Covered Interest Rate Parity
Covered interest rate parity holds that the forward exchange rate must offset the interest rate gap between two currencies, otherwise risk-free arbitrage would be possible.
If Indian rates are higher than US rates, USDINR must trade at a forward premium large enough that an investor gains nothing extra by converting to rupees, earning the higher rate, and converting back via a forward. The forward locks the rate, so the trade is 'covered' and riskless.
When parity breaks, arbitrageurs step in until forward premiums realign with the interest differential. This is why USDINR forward points track the rupee-dollar rate gap rather than anyone's view on the rupee's future direction.
Related terms
- Forward Premium / DiscountA currency trades at a forward premium when its forward rate is higher than spot, and at a discount when lower, driven mainly by the interest rate gap between the two countries.
- Carry TradeA carry trade borrows in a low-yielding currency and invests in a higher-yielding one, profiting from the interest rate differential as long as the exchange rate stays stable.
- Interest Rate DifferentialThe interest rate differential is the gap between interest rates of two countries, a core driver of currency carry trades, forward premiums and long-run exchange rate trends.
- Uncovered Interest Rate ParityUncovered interest rate parity theorises that a higher-yielding currency should depreciate over time by exactly the interest-rate gap, leaving no excess return from a carry trade once exchange-rate moves are accounted for.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.