Covered Interest Rate Parity and Forward Rates: Risk Premiums Are Not Inputs

Summary

The document answers whether a country-specific market risk premium and inflation rates belong in a currency forward-rate calculation. Under covered interest rate parity, the forward exchange rate is determined by the spot exchange rate and the two currencies’ interest rates for the relevant period. The stated calculation uses the spot quote and the domestic and foreign interest rates; the additional inflation and risk-premium figures are not inputs to that parity relationship.

The response cautions that inflation and risk premia may matter in related analyses, even though they are not needed for this forward-rate calculation. It does not explain those other applications, derive the parity formula, or discuss market frictions and deviations from parity. The takeaway is specific to calculating a covered forward from interest rates, rather than forecasting a future spot rate or assessing broader currency risk.

Key ideas

• Covered interest rate parity uses the spot exchange rate and the two relevant interest rates to calculate a forward rate.
• The supplied inflation rates are not required inputs to that calculation.
• The stated market risk premium is also not needed for the covered forward calculation.
• Inflation and risk premia can still matter in related financial analyses.

Tags

# Factoring risk premium in to Forward Rate calculation


# Factoring risk premium in to Forward Rate calculation












This is a self study question. I'm calculating a forward rate.

Specifically, I have that in a country X, the Spot Rate is 5X/1US. I also have that the 1 year interest rate is 13% in country X and inflation is 12%. The US interest rate is 4% with 3% inflation.

I'm computing the forward rate as:

$F= S(1+i_d)/(1+i_f) = 5 *(1+.04)/(1+.13) = 4.602.$

However I'm also told that X's market risk premium is 300 basis points above US treasuries. I'm unsure how to factor that in....

## Answer by rhaskett (score 2, accepted)

https://quant.stackexchange.com/a/15277

You do not need to factor in the risk premium or the inflation rates to get the Forward Rate. The calculation you are making is from the idea of Covered Interest Rate Parity. To calculate the forward rate all you need are the two interest rates.

I'm not sure if the question is trying to confuse by giving extra data. Inflation rates and risk premia can be important for related calculations.

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