Topic Five

Covered Interest Parity

What are the practical business implications of CIP?

Topic Five

Sub-Topics

The CIP Equilibrium Condition

The Mechanics of Covered Arbitrage

Covered Arbitrage with Spread

05-2
Topic Five

Learning Objectives
After completing this topic you should be able to do the following:

Derive the CIP equilibrium condition and explain how it is violated.

Explain effect of covered interest arbitrage.

Modify CIP equilibrium condition allowing for bid/offer spreads.

05-3
Topic Five

References

Textbook

Moosa, I.A., 2004, International Finance: an Analytical
Approach, 2nd edition, McGraw Hill Australia. Chapter
10.

05-4
The CIP Equilibrium Condition
Definition

The Covered Interest Parity (CIP) hypothesis describes

the relationship between the spot rate, the forward rate
and interest rates.

It is an application of the Law of One Price to financial
markets.

05-5
The CIP Equilibrium Condition
Return on Investments
Investor
(K)

Foreign Domestic
investment investment

Converting at
spot rate
K
S

Investing in
foreign assets

K
(1 + i∗ )
S
Reconverting at
forward rate

KF
(1 + i∗ ) K (1 + i )
S

05-6
The CIP Equilibrium Condition
Return on Investments

CIP holds that the returns on an investment in a

domestic financial asset, should equate with the
domestic currency value of the returns on an investment
in a foreign financial asset, when the exchange rate
exposure is hedged (covered) in the forward market.

F
(1 + i ) = (1 + i ∗ )
S
f = i − i∗

05-7
The CIP Equilibrium Condition
Example 5-1: Gross and Net Covered Foreign Return

Spot AUD/CHF exchange rate 0.8500

3-mth AUD/CHF forward rate 0.8585
Australian 90-day bill rate 10.5% pa
Swiss 90-day bill rate 6.50% pa

Calculate gross covered foreign return and compare with

gross domestic return.

Calculate the net covered foreign return and compare it
with the net domestic return.

05-8
The CIP Equilibrium Condition
Example 5-1: Gross and Net Covered Foreign Return

Gross foreign return

F
= (1 + i ∗ )
S
0.8585  0.065 
= × 1 +  = 1.0264
0.8500  4 

Gross domestic return
= (1 + i )
 0.105 
= 1 +  = 1.0263
 4 

05-9
The CIP Equilibrium Condition
Example 5-1: Gross and Net Covered Foreign Return

Net foreign return

F
= (1 + i ∗ ) − 1
S
0.8585  0.065 
= × 1 +  − 1 = 0.0264
0.8500  4 

Net domestic return
= (1 + i ) − 1
 0.105 
= 1 +  − 1 = 0.0263
 4 

05-10
The CIP Equilibrium Condition
Example 5-2: Interest Parity Forward Rate

Spot AUD/CHF exchange rate 0.8500

3-mth AUD/CHF forward rate 0.8585
Australian 90-day bill rate 10.5% pa
Swiss 90-day bill rate 6.50% pa

Calculate interest-parity forward rate and compare it with

actual forward rate.

Calculate the forward spread and compare it with the
interest differential.

05-11
The CIP Equilibrium Condition
Example 5-2: Interest Parity Forward Rate

Calculate interest-parity forward rate and compare it with

actual forward rate.
  0.105  
  1+ 
 (1 + i )   4   = 0.8584
F = S× ∗ 
= 0.8500 × 
 (1 + i )  1 + 0.065 
 4 

The interest-parity forward rate at 0.8584 is less than the

actual forward rate at 0.8585.

05-12
The CIP Equilibrium Condition
Example 5-2: Interest Parity Forward Rate

Calculate the forward spread and compare it with the

interest differential.

Forward spread:
F − S ( 0.8585 − 0.8500 )
f = = = 0.01
S 0.8500

Interest rate differential:
* 0.105 0.065
i −i = − = 0.01
4 4

The comparison is approximate, hence the difference is
not apparent.
05-13
The CIP Equilibrium Condition
Violation of the Equilibrium

If the interest differential and the forward premium are

not equal but have the same sign, there is a quantitative
violation of CIP.

If they have different signs, there is a qualitative violation
of CIP.

05-14
The CIP Equilibrium Condition
Example 5-3: Violation of Parity Conditions

Spot AUD/CHF exchange rate 0.8500

3-mth AUD/CHF forward rate 0.8585
Australian 90-day bill rate 10.5% pa
Swiss 90-day bill rate 6.50% pa

Is there a violation of CIP?

If so, is it a qualitative or a quantitative violation?

05-15
The CIP Equilibrium Condition
Example 5-3: Violation of Parity Conditions

CHF is at a forward premium against the AUD, hence

the foreign interest rate should be lower than the
domestic interest rate, which it is, hence there is no
qualitative violation.

In order to ascertain whether or not there is a
quantitative violation you would need to compare the
gross covered foreign return with the gross domestic
return, which we did in 5-1 and found that they were
quantitatively different.

Hence, there is a quantitative violation of CIP, although a
small violation.
05-16
The Mechanics of Covered Arbitrage
Violation of the Equilibrium

If the forward premium is greater than the interest

differential you can profit by undertaking an outward
arbitrage.

If the forward premium is less than the interest
differential you can profit by undertaking an inward
arbitrage.

05-17
The Mechanics of Covered Arbitrage
Violation of the Equilibrium
Domestic → foreign Foreign → domestic

Borrowing Borrowing
domestic currency foreign currency
1 unit 11unit
unit

Converting at Converting at
spot rate spot rate
1
SS
S
Investing at Loan Loan Investing at
foreign rate repayment repayment domestic rate
1
(1 + i ∗ ) S (1 + i )
S
Reconverting at Reconverting
forward rate at forward rate
F S
(1 + i ∗ ) 1+ i 1 + i∗ (1 + i )
S F
Covered margin Covered margin

F S
(1 + i ∗ ) − (1 + i ) (1 + i ) − (1 + i ∗ )
S F

05-18
The Mechanics of Covered Arbitrage
Example 5-4: Arbitrage Strategy

Spot AUD/CHF exchange rate 0.8500

3-mth AUD/CHF forward rate 0.8585
Australian 90-day bill rate 10.5% pa
Swiss 90-day bill rate 6.50% pa

What would an arbitrager do?

05-19
The Mechanics of Covered Arbitrage
Example 5-4: Arbitrage Strategy

What would an arbitrager do?

The violation probably is too small to warrant doing
anything, particularly after the transaction costs are
taken into account.

However, if it is still profitable after transaction costs are
accounted for then the profitable strategy would be to
undertake an outward arbitrage as the foreign return is
greater than the domestic return.

05-20
The Mechanics of Covered Arbitrage
Outward Covered Arbitrage

Implementing an outward covered arbitrage involves the

following four transactions:
 Borrow at the domestic interest rate;
 Convert into foreign currency at spot rate;
 Invest at the foreign interest rate;
 Reconvert into domestic currency (at the forward rate) and pay
off the loan.

05-21
The Mechanics of Covered Arbitrage
Outward Covered Margin

The outward covered margin may be calculated:

F
π = (1 + i∗ ) − (1 + i)
S

or approximated:
π ≈ i∗ − i + f

05-22
The Mechanics of Covered Arbitrage
The Effect of Outward Arbitrage

Demand for domestic financial assets declines causing a

fall in price and a rise in domestic interest rate.

Demand for foreign financial assets rises causing a rise
in price and a fall in foreign interest rates.

Spot exchange rate rises.

Forward exchange rate falls.

05-23
The Mechanics of Covered Arbitrage
Inward Covered Arbitrage

Implementing an inward covered arbitrage involves the

following four transactions:
 Borrow at the foreign interest rate.
 Convert into domestic currency.
 Invest at the domestic interest rate.
 Reconvert into foreign currency (at the forward rate) and pay off
the loan.

05-24
The Mechanics of Covered Arbitrage
Inward Covered Margin

The inward covered margin may be calculated:

S
π = (1 + i ) − (1 + i* )
F

or approximated:
π ≈ i − i* − f

05-25
The Mechanics of Covered Arbitrage
The Effect of Inward Arbitrage

Demand for domestic financial assets rises causing a

rise in price and a fall in domestic interest rate.

Demand for foreign financial assets falls causing a fall in
price and a rise in foreign interest rates.

Spot exchange rate falls.

Forward exchange rate rises.

05-26
The Mechanics of Covered Arbitrage
Example 5-5: Implementing a Covered Arbitrage

Spot AUD/CHF exchange rate 0.8500

3-mth AUD/CHF forward rate 0.8585
Australian 90-day bill rate 10.5% pa
Swiss 90-day bill rate 6.50% pa

How would the arbitrager implement the arbitrage?

What would be the covered margin?

What would be the effect of the arbitrage?

05-27
The Mechanics of Covered Arbitrage
Example 5-5: Implementing a Covered Arbitrage

How would the arbitrager implement the arbitrage?

The arbitrager would implement an outward arbitrage by:
 Borrowing AUD at 10.5% pa for 90 days.
 Converting the AUD into CHF, by buying the CHF at the spot
rate of 0.8500.
 Investing the CHF at 6.5% pa for 90 days.
 Covering his/her exchange rate risk by selling an amount of
CHF, equal to the gross return on the CHF investment, forward
at 0.8585 in the forward market at 90 days.
 At maturity, after 90 days, the CHF investment will mature, the
forward contract to sell the CHF will need to be settled and the
AUD loan will need to be repaid with interest.

05-28
The Mechanics of Covered Arbitrage
Example 5-5: Covered Margin

What would be the covered margin?

The covered margin on an outward arbitrage:
F
π = (1 + i ∗ ) − (1 + i )
S
0.8585  0.065   0.105 
= 1 +  − 1 +  = 0.0002
0.8500  4   4 

05-29
The Mechanics of Covered Arbitrage
Example 5-5: Effect of the Arbitrage

What would be the effect of the arbitrage?

The effect of the arbitrage will be to alter the supply and
demand for financial assets in each of the financial and
foreign exchange markets concerned such that the price
of the financial assets will move back towards the prices
at which CIP parity is re-established where arbitrage is
no longer profitable.

05-30
The Mechanics of Covered Arbitrage
Example 5-5: Effect of the Arbitrage

Specifically, the following market adjustments will bring

this about:
 In borrowing AUD to invest abroad this will result in a drop in the
demand for AUD financial assets, causing a decrease in the
price of these assets and a consequent rise in the yield on these
assets, represented here by an increase in the domestic interest
rate.
 In buying foreign currency in the spot market, this will increase
the demand for the foreign currency and the supply of the
domestic currency in the spot market, which will increase
domestic currency price of the foreign currency in the spot
market, represented here by an increase in the S exchange rate.

05-31
The Mechanics of Covered Arbitrage
Example 5-5: Effect of the Arbitrage

Specifically, the following market adjustments will bring

this about:
 In investing in the foreign market for financial assets, this will
increase the demand for financial assets in that market leading
to an increase in the price of these assets there and a
subsequent reduction in yield, represented here by a decrease in
the foreign interest rate.
 In selling the foreign currency into the forward market this will
lead to an increase in supply of foreign currency in this market
and an increase in demand for the domestic currency in this
market leading to an decrease in the price of the foreign
currency in the forward market, represented here by a decrease
in the F exchange rate.

05-32
Covered Arbitrage with Spread
Outward Arbitrage with Bid-Offer Spread

Borrow at domestic offer interest rate.

Buy foreign at spot offer exchange rate.

Invest at foreign bid interest rate.

Sell foreign at forward bid exchange rate.

Fb
π = (1 + ib∗ ) − (1 + ia )
Sa

05-33
Covered Arbitrage with Spread
Inward Arbitrage with Bid-Offer Spread

Borrow at foreign offer interest rate.

Sell foreign at spot bid exchange rate.

Invest at domestic bid interest rate.

Buy foreign at forward offer exchange rate.

Sb
π = (1 + ib ) − (1 + ia∗ )
Fa

05-34
Covered Arbitrage with Spread
Example 5-6: Arbitrage and the Spread

Spot AUD/CHF exchange rate 0.8450 – 0.8550

3-mth AUD/CHF forward rate 0.8535 – 0.8635
Australian 90-day bill rate 10.25 – 10.75% pa
Swiss 90-day bill rate 6.250 – 6.750% pa

What would be the covered margin?

05-35
Covered Arbitrage with Spread
Example 5-6: Arbitrage and the Spread

What would be the covered margin?

Fb
π = (1 + ib∗ ) − (1 + ia )
Sa
0.8535  0.0625   0.1075 
= 1 +  − 1 + 
0.8550  4   4 
= −0.0130

The introduction of the bid-offer spread, which is a cost
of arbitrage, has made the arbitrage unprofitable as the
cost associated with the bid-offer spread was greater
than the original profit on the mid-rates.

05-36