Covered Interest Parity

In his 1923 work, ‘A Tract on Monetary Reform,’ John Maynard Keynes introduced the concept of covered interest parity (CIP) that declares how spot and forward foreign exchange rates differ by the ratio of the nominal interest rates in the two currencies.

This seminal work, which assumes no arbitrage conditions, has provided the classic formulation for the calculation of forward foreign exchange pricing for many years:

F = The forward foreign exchange rate

S = The Spot foreign exchange rate

i_d = The domestic interest rate

i_f = The foreign interest rate

Forward Foreign Exchange Swap = F - S

Forward foreign exchange swap (FX forwards) prices are determined by subtracting S from F to find the difference in spot and forward FX rates.

While S refers to the spot rate in this formula, in practice it can also be a forward rate so long as F designates a longer dated forward rate, thus allowing the pricing of forward swaps from any forward date to any other longer dated forward date.  In practice, most FX forwards are quoted vs. U.S. dollars. However, we must observe certain conventions: exchange rate such as EUR/USD and GBP/USD designate USD as the foreign currency, and therefore the foreign interest rate, while pairs such as USD/JPY or USD/CAD designate USD as the domestic.

CIP uses today

CIP provides the basis of pricing, however, there is now much evidence, particularly since the Global Financial Crisis (2008), that systemic frictions or specific demand and supply conditions can and often do cause forward FX pricing to deviate from the no arbitrage conditions that are assumed in CIP. The deviation from CIP implied pricing has become commonly referred to as the cross currency (x-ccy) basis. It is commonly expressed in terms of basis points as an offset to the non-dollar currency in a pair. For example, 3-month EUR/USD x-ccy basis may be quoted as EUR -20bp meaning that the price of a 3-month FX forward swap in EUR/USD would be equivalent to pricing using CIP with an adjustment of the euro interest rate lower by 20 basis points.

Both CIP implied pricing and observed forward FX are therefore crucial to accurate pricing of cross currency basis.

This paper will show how CME Group Interest Rate futures can accurately provide forward interest rates in comparable benchmarks for both U.S. dollars and euros that can be used to formulate the base forward FX swap price implied by CIP. This paper will also illustrate how CME Group FX futures contracts offer highly accurate prices of forward FX that can be used to add transparency to observable x-ccy basis prices.

CME Group launched Three-Month €STR futures (ESR) on October 31, 2022. They join the USD Three-Month SOFR (SR3) contracts listed since May 2018 and now trading over two million contracts per day. ESR contracts have many similarities with the SR3 sharing contract critical dates, final settlement compounding calculation, and contract size ($25 or €25 per contract per basis point). The only notable difference in the contracts is the underlying benchmarks.

Uniquely, CME Group also makes the contracts available to trade as inter-commodity spreads (ICS). These inter-commodity spreads provide functionality that allows customers to trade at a guaranteed price representing the difference in price of each leg, resulting in buying (selling) one leg vs. selling (buying) the other. ICS is available on a 1:1 basis closely matching current levels of EUR/USD= spot price.

Contract critical dates of ESR and SR3 are aligned as defined by the IMM calendar. Notwithstanding holiday differences within periods the alignment of start and end dates allows comparison of expected interest rates in both currencies over the same period.

In addition to Interest Rate contracts, CME Group also lists for trading Foreign Exchange contracts in EUR/USD (6E), which also have expiry dates based on the IMM calendar. The difference between consecutive quarterly FX contracts represents the Forward Pips over that period. Consecutive contracts can be traded as calendar spreads, in increments of 0.2 FX pips, guaranteeing pricing on both legs.

Let us work through an example with the following observed prices in December Interest Rate contracts and both December and March FX contracts:

6EZ2 (Dec 22 €uro FX)                0.9843 (S)

6EH3 (Mar 23 €uro FX)                0.9915 (F)

ESRZ2 (Dec 22 €STR)                   97.785 (i_d)

SR3Z2 (Dec 22 3M SOFR)            95.30 (i_f)

From these prices we can determine that the forward swap price between the December IMM date and the March IMM date is the latter price less the former:

Dec 22 to Mar 23 Euro FX forward swap price = 0.9915 - 0.9843 = 0.0072

This is commonly expressed as forward pips (multiply by 10,000), in this case 72 pips.

For the Interest Rate contracts we observe prices in SR3Z2 at 95.30 and ESRZ3 at 97.785. We can convert these prices to their equivalent yields using the simple formula of R = 100 – P where R is Rate and P is Price.

Dec 22 SOFR = 100 - 95.30 = 4.70%

Dec 22 €STR = 100 - 97.785 = 2.215%

Thus, we have the SOFR implied USD interest rate of 4.70% and the €STR implied €uro interest rate of 2.215% both representing the IMM period from 21 Dec 2022 to 15 Mar 2023.

Using the combination of ESR, SR3 and 6E futures pricing along with the concept of Covered Interest Parity (CIP) we can calculate the forward value, as of 15 March 2023, of 1 €uro and its equivalent in USD, which is 0.9843 according to the price of 6EZ3. In each case the period is 91 days beginning on 21 December 2022.

Therefore applying 91 days of €uro interest at a rate of 2.215% to 1 €uro we would end with:

Similarly in USD we apply 91 days of USD interest at a rate of 4.70% to our starting 98.43 cents.

Thus, we calculate that  1.00559 EUR = 0.995994 USD

Dividing both sides by the euro amount (1.00559) we can express the CIP implied forward rate as:

1 EUR = (0.995994 / 1.00559) =  0.990448 USD

Thus, 1 EUR = 0.990448 USD as of 21 March 2022 and the forward swap rate is:

0.990448 - 0.9843 = 0.006148, or 61.48 pips

We noted above that the observed forward swap from Dec 22 and Mar 23 FX futures is at 72 pips, which is 10.52 pips above the rate implied by the respective USD and €uro interest rates alone. This difference is the observed cross currency basis. We can also, and more commonly would, express the difference in terms of basis points on the €uro leg.

We can rearrange the basic equations of CIP to solve for the foreign interest rate if we know what the forward swap pips are. In our case 72 pips and the known USD interest rate of 4.70% would imply that the required €uro interest rate is 1.7931%: Previously we have the forward value of $0.9843 as $0.995994. Also, our observed forward rate, consistent with 72 pips, is 0.9915. Thus, the forward value of 1 €uro is calculated to be 0.995994/0.9915 = 1.004533. Converting that back to an annualized rate by subtracting 1 and them multiplying by 360/91 yields a result of 0.017931 or 1.7931%.

This rate is 42.19 basis points lower than the rate implied by the €STR futures price of 2.215%. As a result, we would then expect to see the EUR/USD 3-month IMM x-ccy swap starting on Dec 21, 2023 quoted at EUR -42.19bp.