<p>Covered Interest Rate Parity (CIRP) is a macroeconomic concept that describes the relationship between interest rates and exchange rates in a world without currency risk.</p>

<h2>How It Works</h2>
<p>CIRP works on the principle that investors should be indifferent to investing in different currencies due to the absence of currency risk. Here's how:</p>
<ul>
  <li>Consider two countries, A and B, with interest rates i_A and i_B respectively.</li>
  <li>An investor from country A can borrow at i_A and lend in country B at i_B, or vice versa.</li>
  <li>To eliminate currency risk, the investor uses a forward contract to lock in the exchange rate.</li>
  <li>CIRP states that the difference in interest rates should equal the forward premium or discount, i.e., (i_A - i_B) = (F - S), where F is the forward exchange rate and S is the spot exchange rate.</li>
</ul>

<h2>Why It Matters</h2>
<p>CIRP matters for several reasons:</p>
<ul>
  <li><strong>Exchange Rate Determination:</strong> It helps explain how exchange rates are determined in the foreign exchange market.</li>
  <li><strong>International Investment:</strong> It influences international investment decisions by making investors indifferent to currency risk.</li>
  <li><strong>Monetary Policy Transmission:</strong> It facilitates the transmission of monetary policy across countries by influencing capital flows.</li>
</ul>
<p>For instance, if CIRP holds, a sudden increase in interest rates in country A would lead to an appreciation of its currency, attracting more foreign investment and potentially causing its exchange rate to overshoot its long-run equilibrium.</p>