Uncovered Interest Rate Parity: A Comprehensive Guide

Introduction

Uncovered interest rate parity (UIRP) is a financial theory that states that the difference in interest rates between two countries should be equal to the expected change in the exchange rate between their currencies. In other words, it suggests that investors should be able to earn the same return on an investment in one country as they would earn on an investment in another country, after accounting for the exchange rate risk.

The Case for UIRP

There are several reasons why UIRP may hold true:

1. Arbitrage: If there is a difference in interest rates between two countries, investors will arbitrage by borrowing in the low-interest-rate country and investing in the high-interest-rate country. This will drive up the demand for the low-interest-rate currency and drive down the demand for the high-interest-rate currency, leading to an appreciation of the former and a depreciation of the latter, until the interest rate differential is eliminated.
2. Covered Interest Rate Parity: Covered interest rate parity (CIP) states that the forward exchange rate should be equal to the spot exchange rate multiplied by the ratio of the domestic interest rate to the foreign interest rate. If this relationship holds, then UIRP also holds, as the expected change in the exchange rate is equal to the difference in interest rates.
3. Purchasing Power Parity: Purchasing power parity (PPP) states that the exchange rate between two currencies should be equal to the ratio of the price levels of the two countries. If PPP holds, then UIRP also holds, as the expected change in the exchange rate is equal to the difference in inflation rates between the two countries.

Evidence for UIRP

Empirical evidence for UIRP is mixed. Some studies have found that UIRP holds in the long run, while others have found that it does not hold in the short run. The following table summarizes some of the key findings:

As can be seen from the table, the correlation between interest rate differentials and exchange rate changes has increased over time. This suggests that UIRP may be becoming more reliable in recent years.

Deviations from UIRP

There are a number of factors that can cause deviations from UIRP, including:

• Transaction costs: Transaction costs can prevent investors from arbitraging away interest rate differentials.
• Risk aversion: Investors may be risk averse and unwilling to take on the exchange rate risk associated with investing in foreign currencies.
• Government intervention: Governments may intervene in the foreign exchange market to prevent large fluctuations in the exchange rate.
• Structural factors: Structural factors, such as differences in economic growth rates, can lead to persistent deviations from UIRP.

Applications of UIRP

UIRP can be used in a number of applications, including:

• Foreign exchange forecasting: UIRP can be used to forecast future exchange rates. If UIRP holds, then the expected change in the exchange rate is equal to the difference in interest rates between the two countries.
• Investment decisions: UIRP can be used to make investment decisions. If UIRP holds, then investors should be able to earn the same return on an investment in one country as they would earn on an investment in another country, after accounting for the exchange rate risk.
• Hedging: UIRP can be used to hedge against exchange rate risk. If UIRP holds, then investors can hedge against exchange rate risk by investing in a foreign currency and borrowing in the domestic currency.

Conclusion

UIRP is a useful theory that can be used to understand the relationship between interest rates and exchange rates. While UIRP does not always hold perfectly, it can provide valuable insights for foreign exchange forecasting, investment decisions, and hedging.

FAQs

1. What is the difference between UIRP and CIP?

CIP is a special case of U