Covered interest parity and the relative effectiveness of forward and money market hedging

Abstract

In this paper it is shown that obtaining equally effective forward hedging and money market hedging implies and is implied by the validity of covered interest parity. This proposition is demonstrated by constructing combined positions consisting of long exposures on five currencies and short exposures on the hedging instruments. An indirect test of CIP would then boil down to testing the difference between the variances of the rates of return on the combined positions.