Covered Interest Rate Parity (CIP)

Covered Interest Parity (CIP) is an arbitrage relationship: the forward exchange rate must equal the spot rate adjusted for interest rate differentials, otherwise arbitrage opportunities exist. Formula: F/S = (1 + r_domestic)/(1 + r_foreign). Example: If USD rates are 5% and EUR rates are 2%, EUR must trade at a 3% forward premium — otherwise you could borrow EUR at 2%, convert to USD, earn 5%, and lock in the future exchange rate via a forward, capturing risk-free profit. Covered means the FX risk is hedged with a forward. Empirical reality: CIP held tightly pre-2008 but broke down post-crisis due to bank balance sheet constraints, regulation, and cross-currency basis (the deviation from CIP).