Covered Interest Rate Parity is a theoretical condition in which the relationship between interest rates and the spot and forward currency values of two countries are in equilibrium. The covered interest parity situation refers to a condition whereby market interest rates for both currencies would be identical for all maturities. Alternatively, there would be no opportunity for arbitrage using forward contracts, which often exists between markets with different interest rates. This means that the forward contract or forwards market in which currency denominated in one country can be sold at a higher price in another country, will not work if those currencies are not at free-floating parity (FFP).The theory is based on the premise that if interest rates are not equal, it is possible to create an arbitrage opportunity by borrowing in one currency and investing in another. For example, say a U.S.-based investor borrows U.S. dollars at 5% and invests them in Japanese yen for two years at 3%. At maturity, the dollar-yen exchange rate will have appreciated by approximately 10%, creating an opportunity for arbitrage profit of 2%.This is a simplified example, as the actual conditions for arbitrage are much more complex. In reality, many factors can affect the value of different currencies in relation to one another, including economic growth rates and inflation expectations.
