Indicate the meaning of the terms “covered interest parity” (CIP) and “uncovered
ID: 1223433 • Letter: I
Question
Indicate the meaning of the terms “covered interest parity” (CIP) and “uncovered interest parity” (UIP). Then, focusing on “covered interest parity,” explain by numerical example and with at least one graph how such parity is conceptually attained in the context of a home country and a foreign country if the short-term interest rate in the foreign country is greater than the short-term interest rate in the home country at the same time that the spot rate on the foreign currency equals the forward rate on the foreign currency. (Assume that the two interest rates are on comparable assets of the same risk.)
Explanation / Answer
UIP is a parity situation wherein the difference in interest rates between two economies is equal to the expected change in exchange rates between the economies'' currencies
Covered interest rate parity is a situation wherein the relationship between interest rates and the spot and forward currency values of two economies are in equilibrium. So, there are nil interest rate arbitrage opportunities between those two currencies
Example-assume Country A's currency is trading at par with Country B's currency, but the interest rate in Country A is 6% and the interest rate in country B is 3%. All other things remaining equal, it makes sense to borrow in the currency of B, convert it in the spot market to currency A and invest the proceeds in Country A. To repay the loan in currency B, one must enter into a forward contract to exchange the currency back from A to B. Covered interest rate parity exists when the forward rate of converting A to B eliminates all the profit from the transaction