Interest rate parity separates the price of a forward agreed today from the unknown spot rate at maturity. Covered parity compares investments with their currency exchange hedged; uncovered parity concerns expected returns without that hedge. Use named currencies and units before interpreting a rate difference. Retail overnight financing is a separate contract calculation, not automatically the same transaction.

What interest rate parity actually is

Covered interest parity (CIP) relates spot, a contracted forward and comparable borrowing or deposit rates under no-arbitrage assumptions. Here EUR/USD means USD per EUR for both S and F. With simple annual rates and a common year fraction T, F = S × (1 + r_USD × T) / (1 + r_EUR × T). Reversing the quote reverses the ratio. A forward premium or discount prices the contracted exchange; it does not require future spot to reach F.

With hypothetical one-year simple USD and EUR rates of 5% and 1%, respectively, ideal covered parity for EUR/USD gives F/S = 1.05/1.01 = 1.03960396. The forward premium is about 3.9604%, not exactly the four-percentage-point rate difference. The relation assumes comparable maturities and unconstrained borrowing, lending and forward execution before costs.

A principal-only forward leaves interest unhedged

Hypothetical model: a EUR10,000 deposit earns 2% over a year, so EUR10,200 will be exchanged. An agreed forward F = 1.12 USD/EUR covers only the original EUR10,000. The remaining EUR200 must be exchanged at a spot rate not known in advance. Hedging principal does not hedge the full maturity amount.

Scroll sideways to see the full diagram

Forward-covered principal and unhedged interestEUR10,200 is due at maturity. The forward covers EUR10,000; EUR200 interest requires spot exchange. At spot 1.05, proceeds are USD11,410; at 1.20, USD11,440. A full forward gives USD11,424.At maturity: 10,000 + 200 = EUR10,200EUR10,000 x FEUR200 x spot= USD11,200= variable amountSpot 1.05: 11,200 + 210 = USD11,410Spot 1.20: 11,200 + 240 = USD11,440Full EUR10,200 x F = USD11,424Only the full amount has fixed proceeds here.
The narrow orange segment represents 200/10,200 of the actual EUR amount. It is small but remains exposed to spot.

At spot 1.05, partial cover gives USD14 less than full cover; at 1.20, USD16 more. The difference is 200 x (spot - F), arising solely from unhedged interest. First match the currency, date and amount of the future exchange. The word forward alone does not specify how much of the cash flow a contract covers.

Assumptions: EUR10,000 principal and exactly EUR200 interest, in the same currency and due on the same date. F = 1.12 is a fictional agreed contract price, not a result of the earlier CIP formula. Full performance of the contracts; no costs, taxes, counterparty risk or early termination. Method source: CME Group: covered interest parity and forwards.

The covered version — why it holds through arbitrage

For a separate hypothetical one-year model, take S = 1.10 USD/EUR, USD interest 5% and EUR interest 2%. Assume fixed simple rates, simultaneous contracts and full performance, excluding spreads, fees, taxes, credit risk and funding restrictions. Then F = 1.10 × 1.05 / 1.02 = 1.132352941… USD/EUR: a 2.9412% EUR forward premium, not exactly the three-percentage-point rate difference.

USD 11,000 earns USD 550 and becomes USD 11,550. Alternatively, USD 11,000 / 1.10 buys EUR 10,000, which earns EUR 200. A forward agreed at the outset for the entire EUR 10,200 yields exactly USD 11,550 at the unrounded F. This is a cash-flow equality under the stated assumptions; a principal-only hedge leaves interest exposed, as the diagram’s separate F = 1.12 model shows.

The BIS’s September 2016 study discusses persistent CIP deviations since the global financial crisis. Its framework combines hedging demand with tighter limits to arbitrage, including balance-sheet costs and risk constraints. Regulation is part of that context, not the sole explanation. A quoted discrepancy does not establish accessible risk-free profit: compare executable Bid/Ask prices, borrowing and deposit terms, matching maturities and costs. Cross-currency basis can be expressed as a rate adjustment to a specified currency leg; a number of FX pips is not the same number of interest-rate basis points.

The uncovered version and the forward premium puzzle

Uncovered interest parity (UIP) compares expected nominal returns on similar investments without a forward hedge. In a simple version without a risk premium, the higher interest return is offset by expected depreciation of that currency. Expected is not realised: the future exchange rate remains unknown. This hypothesis is distinct from CIP’s contracted cash flows.

Empirical departures from this simple expectation relation are often discussed as the forward-premium puzzle. Their interpretation depends on the sample and measurement: the abstract of a 2023 Federal Reserve study of an emerging economy describes differences across sub-periods, risk premia and expectation errors. That evidence is not a guarantee that UIP always fails or that a carry strategy profits. The article on the impact of Fed decisions on forex addresses policy expectations separately.

How it shows up on your account — swap and carry trade

Retail overnight financing follows the provider’s instrument specification and contract. For example, OANDA Corporation’s US forex page describes liquidity-provider tom-next rates adjusted by an administration fee and date-dependent accrual. It does not supply a universal CFD tariff. Verify your own entity, instrument, long/short rate, units, conversion and schedule. A quoted rate today is not a year-long forecast.

In a hypothetical model, a constant funding credit of 4% a year on a USD100,000 quote-currency exposure is USD4,000, or about USD10.96 per day using 365 days. A 1% adverse price move on that same USD exposure is USD1,000, equal to a quarter of the annual credit. These units and assumptions are chosen for arithmetic; they are not actual broker swap terms.

Honestly — theory versus reality

Consider the earlier 5% USD / 2% EUR model without a hedge. Borrow EUR 10,000, convert to USD 11,000 and deposit the dollars. After one year, USD 11,550 is available and EUR 10,200 is owed. The USD remainder is 11,550 − 10,200 × S_T. At final spot 1.10 it is +USD 330; at 1.15 it is −USD 180; at the exact model F it is zero. These are amounts after repayment, not returns on an unspecified equity capital or guaranteed future outcomes.

Day count also matters. In a separate hypothetical 90-day comparison with S = 1.10, USD 5% and EUR 2%, contract A uses 90/360 for USD and 90/365 for EUR: F ≈ 1.10828449. Contract B uses 90/365 for both: F ≈ 1.10809706. The difference is about 1.87 pips at 0.0001 USD/EUR per pip. These are invented contract conventions, not assigned to real currency products; changing a convention is not by itself evidence of cross-currency basis. The USD/JPY carry trade guide considers a different pair and its currency risk.

What to do tomorrow

  1. Read the broker's instrument specification. Record long and short swap values, calculation mode, unit, account-currency conversion and day multipliers. A negative sum alone does not establish the amount or sole cause of a broker margin; compare the contract terms and relevant funding benchmarks.
  2. Estimate funding using its stated calculation mode. Convert points or other units into account currency for the actual volume, then apply the scheduled day multipliers and conversion rates. Simply multiplying a quoted point number by volume and 365 can give wrong units or double-count accrual. Treat constant future rates only as a hypothetical assumption.
  3. Separate policy news from contract pricing. The two central-bank calendars provide dated events to observe. Relevant market funding terms and provider rates can change between meetings; a policy-rate decision does not mechanically prescribe the overnight charge on your account.
  4. Compare the constructions. Use the fundamental analysis section to distinguish a fully hedged deposit, an unhedged currency borrowing and a retail leveraged position. Record which cash flows and risks each model includes before comparing their results.