A covered interest rate parity is a situation in which the prevailing interest rates of two nations are close but not quite the same, while the current rate of exchange between the currencies of those two countries is considered to be at par. When this type of situation exists, there is the possibility to engage in trading situations that ultimately benefit the buyer or investor, by using a series of steps that involve securing assets with the use of a currency conversion approach. This covered interest rate parity approach allows the investor to take advantage of the best interest rates offered in either of the two countries involved, which in turn means that the overall cost of acquiring the asset is kept to a minimum.
One of the easiest ways to understand how a covered interest rate parity works is to think in terms of two nations in which the currencies of both nations are trading at rate of exchange that is considered to be at par, or at least so similar that the difference is barely perceptible. One nation has a current interest rate that is lower than the other nation. In order to make the best use of this situation, the investor will borrow funds in the currency of the country with the lower rate of interest. Those funds are then converted into the currency of the nation with the higher rate of interest and used for investments such as bonds, taking advantage of the higher interest rate. When structured efficiently, the current interest rate parity approach allows the investor to create a forward contract that is used to ultimately repay the original debt in the currency of the nation with the lower interest rate, and generate a profit from the difference in interest rates between the two nations.
In order for a covered interest rate parity strategy to work, all the components of the method must be completed while the two currencies are still trading at par. For this reason, the investor will normally make use of the forward contract to lock in the right interest rates to repay the amount originally borrowed. Failure to complete this important step in the process could either reduce the returns generated from the strategy, or possibly offset them altogether and leave the investor exposed to the possibility of incurring a loss from the effort.
Since the currency of nations rarely remain at par with one another for very long, speed is important to making a covered interest rate parity scheme work. This means that arranging the loans involved and putting together the contracts to lock in the current interest rates is essential. For this type of approach, even seasoned investors will want to engage the services of a competent broker or dealer, so that the potential for leaving some aspect of the arrangement undone is kept to a minimum.