what does covered interest rate parity tell you 
covered interest rate parity is a no arbitrage condition that could be used in the foreign exchange markets to determine the forward foreign exchange rate the condition also states that investors could hedge foreign exchange risk or unforeseen fluctuations in exchange rates with forward contracts consequently the foreign exchange risk is said to be covered interest rate parity may occur for a period but that does not mean it will remain because interest rates and currency rates change over time example of how to use covered interest rate parityas an example assume country x s currency is trading at par with country z s currency but the annual interest rate in country x is 6 and the interest rate in country z is 3 all other things being equal it would make sense to borrow in the currency of z convert it in the spot market to 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 exchange the currency back from x to z covered interest rate parity exists when the forward rate of converting x to z eradicates all the profit from the transaction since the currencies are trading at par one unit of country x s currency is equivalent to one unit of country z s currency assume that the domestic currency is country z s currency therefore the forward price is equivalent to 0 97 or 1 x 1 3 1 6 looking at the currency markets we can apply the forward foreign exchange rate formula to figure out what the gbp usd rate might be say the spot rate for the pair was trading at 1 35 also assume that the interest rate using the prime lending rate for the u s was 1 1 and 3 25 for the u k the domestic currency is the british pound making the forward rate 1 32 or 1 35 x 1 0 011 1 0 0325 the difference between covered interest rate parity and uncovered interest rate paritycovered interest parity involves using forward contracts to cover the exchange rate meanwhile uncovered interest rate parity involves forecasting rates and not covering exposure to foreign exchange risk that is there are no forward rate contracts and it uses only the expected spot rate there is no difference between covered and uncovered interest rate parity when the forward and expected spot rates are the same limitations of using covered interest rate parityinterest rate parity says there is no opportunity for interest rate arbitrage for investors of two different countries but this requires perfect substitutability and the free flow of capital sometimes there are arbitrage opportunities this comes when the borrowing and lending rates are different allowing investors to capture riskless yield for example the covered interest rate parity fell apart during the great financial crisis however the effort involved in capturing this yield usually makes it non advantageous to pursue 