Indicate the Meaning of the Terms "Covered Interest Parity" (CIP)

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The Answer is Covered interest parity (CIP) and uncovered interest parity (UIP) are concepts in international finance that relate to the relationship between interest rates and exchange rates.

CIP refers to the condition where the interest rate differential between two countries is equal to the forward premium or discount on the foreign currency. In other words, it implies that investors can lock in a certain rate of return on their investment in a foreign currency through a combination of the spot exchange rate, the foreign interest rate, and the forward exchange rate.

UIP, on the other hand, suggests that the expected change in the exchange rate between two countries is equal to the difference in their interest rates. This means that investors should be indifferent between investing in domestic or foreign assets, as the expected return from investing in a foreign currency should be equal to the return from investing in the domestic currency.

Now, let's focus on covered interest parity and how it is conceptually attained in the context of a home country and a foreign country when the short-term interest rate in the foreign country is greater than the short-term interest rate in the home country, while the spot rate on the foreign currency equals the forward rate on the foreign currency.

Assuming that the two interest rates are on comparable assets of the same risk, let's consider a numerical example to illustrate covered interest parity.

Suppose the short-term interest rate in the home country is 3%, and the short-term interest rate in the foreign country is 5%. Additionally, let's assume that the spot rate on the foreign currency is 1.2 units of foreign currency per unit of domestic currency, and the forward rate on the foreign currency is also 1.2 units of foreign currency per unit of domestic currency.

To attain covered interest parity, investors would need to compare the returns from investing in the domestic currency and the foreign currency. If the foreign interest rate is higher, investors would expect a higher return from investing in the foreign currency. However, the forward exchange rate should reflect this interest rate differential to ensure that there is no arbitrage opportunity.

In this example, if an investor in the home country invests in the domestic currency at a 3% interest rate, they would expect to receive a return of 103 units of domestic currency after one year for every 100 units invested. On the other hand, if they invest in the foreign currency at a 5% interest rate, they would expect to receive a return of 105 units of foreign currency after one year for every 100 units invested.

Now, if the spot rate and the forward rate on the foreign currency are both 1.2 units of foreign currency per unit of domestic currency, it means that the forward exchange rate is not offering any premium or discount on the foreign currency. This ensures that the return from investing in the foreign currency is effectively equal to the return from investing in the domestic currency, accounting for the interest rate differential.

In summary, covered interest parity is conceptually attained when the interest rate differential between two countries is equal to the forward premium or discount on the foreign currency, ensuring that there are no arbitrage opportunities for investors. This equilibrium is maintained through the relationship between interest rates and exchange rates, as illustrated in the numerical example and graph.

Indicate the Meaning of the Terms "Covered Interest Parity" (CIP)

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