The goals of this chapter are: To outline reasons for interest in covered interest parity (CIP), to describe the CIP condition, to describe the mechanics of covered arbitrage, to explain deviations from CIP. | Chapter 10 Covered Interest Parity Objectives To outline reasons for interest in covered interest parity (CIP). To describe the CIP condition. To describe the mechanics of covered arbitrage. To explain deviations from CIP. Definition The CIP hypothesis describes the relationship between the spot rate, the forward rate and interest rates. It is an application of LOP to financial markets. Reasons for interest in CIP It can be used as a measure of capital mobility. It links the term structure of interest rates with the term structure of forward spreads. Reasons for interest in CIP (cont.) It implies optimal resource allocation in a market economy. It has implications for financing and investment decisions. The CIP Equilibrium Condition Return on Investments Converting at spot rate Investing in foreign assets Reconverting at forward rate Domestic investment Foreign investment Investor (K) Covered Interest Arbitrage Covered margin Investing at domestic rate Domestic foreign Borrowing domestic currency Converting at spot rate Investing at foreign rate Foreign domestic Borrowing foreign currency Converting at spot rate S 1 unit Reconverting at forward rate Loan repayment Loan repayment Covered margin 1 unit 1 unit Reconverting at forward rate S Profit from Covered Arbitrage (Domestic→Foreign) The Interest Parity Forward Rate Covered Arbitrage with Bid-Offer Spreads (Domestic→Foreign) Covered Arbitrage with Bid-Offer Spreads (Foreign→Domestic) Arbitrage with Bid-Offer Spreads Covered margin Investing at domestic bid rate Domestic foreign Borrowing domestic currency Converting at spot offer rate Investing at foreign bid rate Foreign domestic Borrowing foreign currency Converting at spot bid rate S 1 unit Reconverting at forward bid rate Loan repayment Loan repayment Covered margin 1 unit 1 unit Reconverting at forward offer rate Covered Arbitrage and Consistency of Cross Forward Rates Covered arbitrage and three-point arbitrage in the spot market can maintain the . | Chapter 10 Covered Interest Parity Objectives To outline reasons for interest in covered interest parity (CIP). To describe the CIP condition. To describe the mechanics of covered arbitrage. To explain deviations from CIP. Definition The CIP hypothesis describes the relationship between the spot rate, the forward rate and interest rates. It is an application of LOP to financial markets. Reasons for interest in CIP It can be used as a measure of capital mobility. It links the term structure of interest rates with the term structure of forward spreads. Reasons for interest in CIP (cont.) It implies optimal resource allocation in a market economy. It has implications for financing and investment decisions. The CIP Equilibrium Condition Return on Investments Converting at spot rate Investing in foreign assets Reconverting at forward rate Domestic investment Foreign investment Investor (K) Covered Interest Arbitrage Covered margin Investing at domestic rate Domestic foreign Borrowing .
