Exploring How Cover Rate Forex Helps You Hedge Against Potential Exchange Rate Fluctuations

Exchange rates are constantly changing; they fluctuate based on trading volume, market sentiment, and several other factors. These fluctuations can raise concerns for you if they don‘t turn out as expected. That’s why many like you are resorting to a cover rate forex strategy.

Often associated with covered interest rate arbitrage, this strategy allows investors to borrow in a low-interest currency and convert it into a currency bearing high interest rates. Then follows the investment in that currency and a forward contract to get the original currency at a predetermined rate. This helps eliminate the exchange rate risk. Considering that it may sound complex, we prepared an useful guide on the cover rate forex phenomenon. Read on to understand the process.

Covered Interest Rate Parity and How It Protects You Against Forex Volatility

Covered Interest Rate Parity (CIRP) or cover rate forex is a popular forex concept where the difference in interest rates of two countries currencies should reflect in the forward exchange rate. It thus means that the whole process of borrowing a low-interest currency, converting it to a currency with higher interest rates, investing, and then using a forward contract to convert to the original currency should work in a way to eliminate the potential profit from fluctuations in exchange rates. The forward contract used in it helps cover or hedge the exchange rate risk.

Interest Rate Parity Condition Formula

The forward exchange rate is calculated using the formula below.

F = S x (1+id)/(1+if)

Where,

‘F’ stands for forward exchange rate.

‘S’ remains the existing spot exchange rate.

‘id’ is the domestic or base currencys interest rate.

‘if’ remains the quoted or foreign currencys interest rate.

Demonstrating Covered Interest Rate Parity with an Example

Example - You are contemplating a cover rate forex concept, keeping USD and GBP as two currencies. Assume that both of these US and UK-based currencies are trading at par. However, if the annual interest rate of the US is 8% and 4% in the UK, it would be better to borrow in GBP (the UK-based currency), convert it to USD in the spot market, and invest the amount in the US. However, to repay the loan in GBP, entering into a forward contract makes sense. With that, you can exchange USD for the former. Covered interest rate parity thus comes into the equation and helps eliminate the gains from the transaction.

As USD and GBP are trading at par, a unit of one currency is equivalent to another.

Forward price would thus be

1 x [(1+4%)/(1+8%)] = 0.96

How Different is Covered Interest Rate Parity from Uncovered Interest Rate Parity?

Yes, both these terms exist and have their own implications for forex investors. While covered interest parity covers the exchange rate using forward contracts, uncovered interest rate parity deals with rate forecasting and covering exposure associated with foreign exchange risks. The uncovered interest rate parity thus does not have forward rate contracts. Instead, it uses just the expected spot rate. If the forward and expected spot rates become equal, covered and uncovered interest rate parity will remain the same.

Conclusion

Understanding cover rate forex helps you make decisions that efficiently manage your risks. Its a powerful tool to protect your forex exposure against market volatility.

So next time you hear about forex fluctuations, use the cover rate forex strategy to cover your risks smartly.

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