1. What is Covered Interest Rate Parity?

Covered Interest Rate Parity (CIRP) is a financial theory that states that the forward exchange rate should incorporate the interest rate differential between two countries. It ensures that there are no arbitrage opportunities when using forward contracts to hedge against exchange rate risk.

2. How Does the Calculator Work?

The calculator uses the Covered Interest Rate Parity formula:

Where:

• \( F \) — Forward Exchange Rate
• \( e_o \) — Current Spot Exchange Rate
• \( r_f \) — Foreign Interest Rate (as decimal)
• \( r_d \) — Domestic Interest Rate (as decimal)

Explanation: The formula calculates the theoretical forward exchange rate that should prevail to prevent arbitrage opportunities between domestic and foreign investments.

3. Importance of Covered Interest Rate Parity

Details: CIRP is fundamental in international finance for pricing forward contracts, managing currency risk, and understanding the relationship between interest rates and exchange rates in global markets.

4. Using the Calculator

Tips: Enter the current spot exchange rate, foreign interest rate (as percentage), and domestic interest rate (as percentage). All values must be positive numbers.

5. Frequently Asked Questions (FAQ)

Q1: What is the difference between covered and uncovered interest rate parity?
A: Covered interest rate parity uses forward contracts to hedge exchange rate risk, while uncovered interest rate parity does not involve hedging and relies on expected future spot rates.

Q2: When does covered interest rate parity hold?
A: CIRP typically holds in efficient markets with free capital movement, no transaction costs, and similar risk characteristics between investments.

Q3: What causes deviations from covered interest rate parity?
A: Deviations can occur due to transaction costs, capital controls, credit risk differences, and market inefficiencies.

Q4: How is this used in practice?
A: Financial institutions use CIRP to price forward contracts, while multinational corporations use it for hedging currency exposure in international transactions.

Q5: What are the limitations of this model?
A: The model assumes perfect capital mobility, no transaction costs, and that assets in different currencies are perfect substitutes, which may not always hold in real markets.