An uncovered interest rate parity (UIRP) explains how foreign and domestic interest rates and currency exchange rates are related. Interest rate parity is based on the idea that, in a global economy, prices are the same everywhere (the law of one price) after interest rates and currency exchange rates are taken into account. Contrary to UIRP, covered interest rate parity involves the use of forward contracts to hedge currency exchange rates. Here is explained UIRP in detail.
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Defining Uncovered Interest Rate Parity
UIRP, or the Uncovered Interest Rate Parity, is a financial concept asserting that the variance between nominal interest rates in two nations corresponds to changes in their foreign exchange rates. This theory bears resemblance to the economic principle known as the ‘Law of One Price (LOOP).’ Similar to UIRP, LOOP posits that identical commodities or financial assets should hold the same price worldwide, factoring in currency exchange rates.
By aligning interest rate differentials with foreign exchange rates, UIRP aims to prevent investors from gaining excessive returns due to currency fluctuations. The model operates on the assumption that the nation with the higher interest rate will witness depreciation in its domestic currency value compared to the nation with the lower interest rate.
Uncovered Interest Rate Parity Condition
UIRP condition comprises two key elements:
- Capital Mobility in the Market: UIRP assumes unrestricted movement of capital in financial markets. This means investors can freely allocate funds across different currencies without facing barriers or restrictions.
- Non-Arbitrage Condition: UIRP adheres to a no-arbitrage condition. If this condition is breached, it creates an opportunity for risk-free profits. Essentially, if the exchange rates and interest rate differentials do not align as predicted by UIRP, it allows for exploiting market inefficiencies to make profits without taking on any risk.
Uncovered Interest Rate Parity Formula
To understand the formula, it is essential to understand the terminology. Spot exchange rates refer to current exchange rates, while forward exchange rates refer to future exchange rates. From days to years, forward rates are offered by a variety of banks and currency dealers.
Swap points are the difference between spot rates and forward rates. A positive difference is called a forward premium. Negative differences are referred to as forward discounts. When a currency with a lower interest rate trades against one with a higher interest rate, the forward premium occurs.
The equations for covered and uncovered IRPs are different. Covered IRPs show forward exchange rates, while uncovered IRPs show spot rates.
The uncovered interest rate parity formula is as follows:
ST(a/b) = St(a/b) * (1+ ia) / (1 + ib)
Here are the components of the equation:
- ST(a/b) = The Spot Rate
- St(a/b) = Expected Spot Rate at time T
- Ft(a/b) = The Forward Rate
- T = Time to Expiration Date
- ia = Interest Rate of Country A
- ib = Interest Rate of Country B
Limitations of Uncovered Interest Parity
Although there is a limited amount of evidence to support UIP, economists, academics, and analysts continue to use it as a theoretical and conceptual model for rational expectation. UIP assumes that capital markets are efficient.
But, when we look at what has actually happened in the real world over shorter and medium-term periods, it turns out that the currency with higher interest rates doesn’t always behave the way UIP predicts. Sometimes, instead of getting weaker, the currency with higher interest rates actually gets stronger. This goes against what UIP
Covered Vs Uncovered Interest Rate Parity
Future Rates
When assessing exchange rates, covered interest rate parity uses future or forward rates, which allows for potential hedging. A UIRP takes into account expected rates, which means forecasting future rates. Hence, it uses an estimation of the expected future rate rather than the actual forward rate.
Difference in Exchange Rates
In covered interest rate parity, the difference between interest rates is adjusted in the forward discount/premium. Through a forward cover, investors are able to borrow from a lower interest rate currency and invest in a higher interest rate currency. Forward covers eliminate all investment risks. In contrast, uncovered interest for parity takes into account the expected depreciation of the domestic currency to adjust the difference between interest rates. Investors don’t benefit from forward cover in a UIRP situation.
Conclusion
Uncovered interest rate parity suggests that currency exchange rates should balance out the differences in interest rates between two countries. In some cases, however, this theory may not hold true. A number of macroeconomic factors, including monetary policy, foreign exchange market distortions, and time horizons, can affect the validity of this theory. Because of these complications, smart investors might seize the chance to make money. They can borrow money in their own country where the interest rates are low and then use that money to buy a foreign currency with higher interest rates.
