Relationship of Forward to Spot Covered

Interest Rate Parity

The forward rate for any two currencies is a function of their spot rate and the interest rate differential between them. For major currencies, the interest rate differential is determined in the Euro currency deposit market.Under the covered interest rate parity principle, and with the opportunity of arbitrage, the forward rate will tend toward an equilibrium point at which any difference in Euro currency interest rates between the two currencies would be exactly offset, or neutralized, by a premium or discount in the forward rate.

If, for example, six-month Euro-dollar deposits pay interest of 5 percent per year, and six-month Euro-yen deposits pay interest of 3 percent per year, and if there is no premium or discount on the forward yen against the forward dollar, there would be an opportunity for “round-tripping” and an arbitrage profit with no exchange risk.

Thus, it would pay to borrow yen at 3 percent, sell the yen spot for dollars and simultaneously resell dollars forward for yen six months hence, meanwhile investing the dollars at the higher interest rate of 5 percent for the six-month period. This arbitrage opportunity would tend to drive up the forward exchange rate of the yen relative to the dollar (or force some other adjustment) until there were an equal return on the two investments after taking into account the cost of covering the forward exchange risk.

Similarly, if short-term dollar investments and short-term yen investments both paid the same interest rate, and if there were a premium on the forward yen against the forward dollar, there would once again be an opportunity for an arbitrage profit with no exchange risk, which again would tend to reduce the premium on the forward yen (or force some other adjustment) until there were an equal return on the two investments after covering the cost of the forward exchange risk.

In this state of equilibrium, or condition of covered interest rate parity, an investor (or a borrower) who operates in the forward exchange market will realize the same domestic return (or pay the same domestic cost) whether investing (borrowing) in his domestic currency or in a foreign currency, net of the costs of forward exchange rate cover. The forward exchange rate should offset, or neutralize, the interest rate differential between the two currencies.