5.2　Covered interest parity

In the section above we came across the law of one price (LOP), which was applied to commodity markets.In this section we apply the LOP to financial markets, in which case we will be concerned with asset prices and consequently with rates of return.One of the relationships describing the LOP in financial markets is covered interest parity (CIP), which stipulates that once foreign exchange risk is covered by a forward contract, then assets with similar characteristics must offer the same return.CIP, which is the second parity condition we study after PPP, represents an equilibrium condition that is restored and maintained by covered interest arbitrage.CIP has important implications for international financial operations such as hedging, investing and financing.