What is covered interest parity
Covered interest parity (CIP) is the rule that the gap between a currency pair's forward rate and spot rate, measured in forward points, equals the difference between the interest rates of the two currencies over the same period.
A forward rate is the exchange rate agreed today for a deal settled on a later date (see forward contract). "Covered" means the currency risk is locked in with that forward, so no exchange rate guess is involved.
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Covered interest parity formula
For a pair written BASE/QUOTE:
Forward rate = Spot rate × (growth factor of the quote currency ÷ growth factor of the base currency)
A growth factor is what a unit of money grows to after earning that currency's interest rate for the forward period. The period is scaled to the deal length and uses each currency's day-count convention.
What follows from the formula:
- If the quote currency has the higher interest rate, the forward is above spot. Forward points are positive, and the base currency trades at a forward premium.
- If the base currency has the higher rate, the forward is below spot. Forward points are negative.
- Forward points ≈ spot × rate differential × time. This shortcut works for short periods and small differentials.
Worked example: USD/PKR
This is a hypothetical walk-through. Use your own spot rate and interest rates if you want actual figures.
Take the USD/PKR spot rate. The base is USD and the quote is PKR.
The PKR rate comes from the State Bank of Pakistan's policy rate. The latest decision: SBP policy rate raised by 50 bps to 12% with effect from 27.10.2026 (MPC). This sits well above typical USD money-market rates.
Because PKR, the quote currency, earns more interest, its growth factor is larger. So the forward USD/PKR rate comes out above spot.
Check the arbitrage logic. Someone holding PKR can either:
- deposit the PKR at the PKR rate, or
- convert to USD at spot, deposit at the USD rate, and lock the conversion back to PKR with a forward.
CIP says both routes end with the same PKR amount. If they did not, the cheaper route would be borrowed and the dearer one lent until prices adjusted (see arbitrage).
When the policy rate rises by some basis points, the differential widens. Under CIP, the forward premium on USD should widen too.
Where the term appears
- Interbank and bank quotes. USD/PKR forward premiums for different tenors are quoted by banks and reported in business news. Commentary links their moves to the rate gap with the US.
- FX swap points. An FX swap is a spot deal plus an offsetting forward. It is priced with the same formula, so dealers quote it in points.
- Overnight swaps on CFD accounts. The rollover charge or credit on a leveraged forex position reflects the rate differential, plus the provider's markup. See swap fees. Leveraged CFD trading can lose money fast, and swaps add to costs on positions held for a long time.
- Central bank and research reports. Reports discuss the "cross-currency basis", which measures deviations from CIP.
Edge cases for experienced readers
- Cross-currency basis. Since the global financial crisis, CIP has not held exactly in major pairs. Bank balance-sheet costs, demand for dollar funding and counterparty risk leave a persistent basis.
- Capital controls and convertibility. Where moving money across borders is restricted, as with PKR, the arbitrage cannot be fully done. Quoted forwards can then drift from the formula, and non-deliverable forwards may price differently from onshore ones.
- Which rates to use. Policy rates, interbank rates and the rates a retail depositor actually gets all differ. CIP holds best with the rates dealers actually fund at.
- Bid-ask spreads and day counts. These create a no-arbitrage band rather than a single exact point.
- Uncovered interest parity is different. It claims the expected future spot rate will offset the differential. That is a theory about forecasts, not a pricing identity, and it often fails.
Related terms
Forward points · Forward contract · Arbitrage · Basis point · Currency risk · Future and present value · Trading glossary
Frequent questions
What is covered interest parity in simple words?
It says the forward exchange rate already includes the interest gap between two currencies. Because of this, hedging away the currency risk wipes out any extra gain from the higher-rate currency.
Why is it called "covered"?
The investor covers, or hedges, the currency risk with a forward contract. The uncovered version has no hedge.
Does a higher Pakistani policy rate make USD/PKR forwards higher?
Under CIP, a wider gap between PKR and USD rates widens the forward premium on USD. Actual quotes can deviate because of capital controls and funding costs.
Can retail traders profit from CIP gaps?
In practice, deviations are small and hard to capture. They usually need bank-level funding and access to both money markets. Retail spreads and fees normally exceed any gap.