Background

The covered interest parity hypothesis describes the equilibrium relationship between the spot exchange rate, the forward exchange rate, domestic interest rates and foreign interest rates.In essence, this theory is an application of the law of one price to financial markets, postulating that, when foreign exchange risk is covered in the forward market, the rate of return on a domestic asset must be the same as that on a foreign asset with similar characteristics.If this is not the case, then covered interest arbitrage is set in motion and continues until the resulting changes in the forces of supply and demand (for the underlying assets)lead to a restoration of the equilibrium condition implied by CIP.

Although CIP was originally developed by Keynes in the 1920s as the earliest theory of forward exchange rate determination, the last two decades or so have witnessed a tremendous revival of interest in the theory for several reasons.Firstly, CIP may be used to measure the degree of international capital mobility.In this case, lack of mobility is indicated by the extent of the deviation from the equilibrium condition implied by CIP.Secondly, CIP is also viewed as linking the term structure of interest rates with the term structure of the forward exchange spreads.Thirdly, CIP is important from a policy perspective because it implies that, if market forces are allowed to work freely, financial resources will be allocated around the world in an optimal manner.The empirical failure of CIP would, therefore, imply the failure of market forces in allocating resources, justifying government intervention in capital and foreign exchange markets.Finally, CIP is important from a business perspective because it has some implications for hedging as well as short-term investing and financing decisions.