The Covered Interest Parity Hypothesis

Abstract

The covered interest parity (CIP) hypothesis — which postulates an equilibrium relationship between the spot exchange rate, the forward exchange rate, domestic interest rates and foreign interest rates — was originally developed by Keynes (1923). In essence, it is the earliest theory of forward exchange, stipulating that the forward exchange rate tends to be equal to its interest parity rate (that is, the spot exchange rate adjusted by a factor reflecting the interest rate differential on domestic and foreign short-term financial assets). Put differently, the forward premium (discount) is postulated to be equal to the short-term interest differential. If the short-term interest rates on domestic and foreign assets with similar risk characteristics are not the same, then covered interest arbitrage will be profitable unless or until the forward premium (discount) is equal to the short-term interest rate differential (the actual forward rate is equal to its interest parity rate). Once equality is reached, any opportunity for arbitrage profit will be eliminated; consequently, the tendency for the movement of funds in either direction will disappear.