Covered interest parity (CIP) (抛补利率平价)

Covered interest parity (CIP) (抛补利率平价 pāo bǔ lì lǜ píng jià) is a theoretical condition in which the relationship between interest rates and the spot and forward currency values of two countries are in equilibrium (平衡 píng héng).

  • Example: Assume Country X’s currency is trading at par with Country Z’s currency, but the annual interest rate (利率 lì lǜ) in Country X is 6% and the interest rate in country Z is 3% (arbitrage opportunity). All other things being equal, it would make sense to borrow in the currency of Z, sell it (抛售 pāo shòu) in the spot market to exchange for currency X and invest the proceeds in Country X. However, to repay the loan in currency Z, one must enter into a forward contract to buy the currency back (补回 bǔ huí) from X to Z. Covered interest rate parity exists when the forward rate of converting X to Z eradicates all the arbitrage opportunities (平价 píng jià) from the transaction.

Part 1: Breakdown of Words

  • ” (pāo) as in “discard” (抛弃 pāo qì), “polish” (抛光 pāo guāng), or “sell in big quantities (in anticipation of or in order to bring about a fall in price)” (抛售 pāo shòu).
  • ” (bǔ) as in “supply” (补给 bǔ jǐ), “supplement” (补充 bǔ chōng), or “subsidy” (补贴 bǔ tiē).
  • “Interest rate” (利率 lì lǜ) as in “nominal interest rate” (名义利率 míng yì lì lǜ).
    • ” (lì) as in “interest” (利息 lì xī), “profit” (利润 lì rùn), or “utilize” (利用 lì yòng).
    • ” (lǜ) as in “probability” (概率 gài lǜ), or “ratio” (比率 bǐ lǜ).
  • “Parity” (平价 píng jià) as in “purchasing power parity” (购买力平价 gòu mǎi lì píng jià).
    • ” (píng) as in “balance” (平衡 píng héng), “horizontal” (水平 shuǐ píng), or “average” (平均 píng jūn).
    • ” (jià) as in “price” (价格 jià gé), “value” (价值 jià zhí), or “cost” (代价 dài jià).
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