Covered interest parity
The arbitrage condition that a forward premium or discount exactly offsets the interest rate differential, so hedged foreign deposits earn the same as domestic ones. Unlike the other parities it holds closely in practice.
Where you will meet it
Covered interest parity appears in 4 learning outcomes on the CFA syllabus. A few of them:
- Explain the international parity conditions, namely interest rate parity in its covered and uncovered forms, the international Fisher effect, purchasing power parity and forward rate parity
“Covered interest parity is an arbitrage condition: the forward premium offsets the interest differential, so a hedged foreign deposit earns the domestic rate.”
- Explain how yield curve positions are taken across more than one currency
“If the currency is hedged with forwards, covered interest parity means the hedged return is roughly the local return plus the short-term rate differential (domestic rate − foreign rate), so hedging gives up much of a high-yield market's extra yield.”
- Recognise and interpret how economies are connected through growth, interest rates and currencies
“Exchange rate linkages: covered interest parity ties forward rates to rate differentials, while real rate differentials, relative growth and risk appetite drive spot rates.”
- Illustrate how currency forwards, futures and swaps alter the risk and return of a portfolio
“Covered interest parity sets the forward price, so hedging a currency whose interest rates exceed the base currency's gives up that yield gap, while hedging a lower-yielding one earns it.”
See also
Practise it
Practise covered interest parity until it is automatic: questions that explain every wrong option.
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