Uncovered Interest Rate Parity (UIP)
What Is Uncovered Interest Rate Parity (UIP)?
Uncovered interest rate parity (UIP) theory states that the difference in interest rates between two countries will rise to the relative change in currency foreign exchange rates over a similar period. It is one form of interest rate parity (IRP) utilized alongside covered interest rate parity.
On the off chance that the uncovered interest rate parity relationship doesn't hold, then, at that point, there is an opportunity to create a risk-free gain utilizing currency arbitrage or Forex arbitrage.
The Formula for Uncovered Interest Rate Parity Is:
Step by step instructions to Calculate Interest Rate Parity
Forward exchange rates for currencies are exchange rates at a future point in time, rather than spot exchange rates, which are current rates. A comprehension of forward rates is fundamental to interest rate parity, particularly in accordance with arbitrage (the simultaneous purchase and sale of an asset to profit from a difference in the price).
Forward rates are accessible from banks and currency dealers for periods going from under seven days to as far out as five years and then some. Similarly as with spot currency citations, forwards are quoted with a bid-ask spread.
The difference between the forward rate and spot rate is known as swap points. In the event that this difference (forward rate minus spot rate) is positive, it is known as a forward premium; a negative difference is named a forward discount.
A currency with a lower interest rate will trade at a forward premium corresponding to a currency with a higher interest rate. For instance, the U.S. dollar regularly trades at a forward premium against the Canadian dollar; on the other hand, the Canadian dollar trades at a forward discount versus the U.S. dollar.
What Does Uncovered Interest Rate Parity Tell You?
Uncovered interest rate parity conditions comprise of two return streams, one from the foreign money market interest rate on the investment and one from the change in the foreign currency spot rate. Said another way, uncovered interest rate parity expects foreign exchange equilibrium, in this manner suggesting that the expected return of a domestic asset (i.e., a risk-free rate like a U.S. Treasury Bill or T-Bill) will rise to the expected return of a foreign asset in the wake of adjusting for the change in foreign currency exchange spot rates.
At the point when uncovered interest rate parity holds, there can be no excess return earned from simultaneously going long a higher-yielding currency investment and shorting an alternate lower-yielding currency investment or interest rate spread. Uncovered interest rate parity expects that the country with the higher interest rate or risk-free money market yield will experience depreciation in its domestic currency relative to the foreign currency.
UIP is connected with the purported "law of one price," which is an economic theory that states the price of an indistinguishable security, commodity, or product traded anyplace in the world ought to have a similar price paying little mind to location when currency exchange rates are thought about — assuming it is traded in a free market with no trade limitations.
The "law of one price" exists since differences between asset prices in various locations ought to ultimately be wiped out due to the arbitrage opportunity. The law of one price theory is the supporting of the concept of purchasing power parity (PPP). Purchasing power parity states that the value of two currencies is equivalent when a basket of indistinguishable goods is priced similar in the two countries. This connects with a formula that can be applied to compare securities across markets that trade in various currencies. As exchange rates can shift often, the formula can be recalculated consistently to recognize mispricings across different international markets.
The Difference Between Covered Interest Rate Parity and Uncovered Interest Rate Parity
Covered interest parity (CIP) includes utilizing forward or futures contracts to cover exchange rates, which can consequently be hedged in the market. In the mean time, uncovered interest rate parity (UIP) includes forecasting rates and not covering exposure to foreign exchange risk — that is, there are no forward rate contracts, and it utilizes just the expected spot rate.
There is no hypothetical difference among covered and uncovered interest rate parity when the forward and expected spot rates are something similar.
Limitations of Uncovered Interest Parity
There is just limited evidence to support UIP, however financial specialists, scholastics, analysts actually use it as a hypothetical and conceptual system to address rational expectation models. UIP requires the assumption that capital markets are efficient.
Empirical evidence has shown that over the short-and medium-term time spans, the level of depreciation of the higher-yielding currency is not exactly the ramifications of uncovered interest rate parity. Ordinarily, the higher-yielding currency has fortified rather than debilitated.
Features
- UIP can be stood out from covered interest rate parity, which includes utilizing forward contracts to hedge exchange rates for forex traders.
- Uncovered interest rate parity (UIP) is a fundamental equation in economics that oversees the relationship among foreign and domestic interest rates and currency exchange rates.
- The essential reason of interest rate parity is that, in a global economy, the price of goods ought to be the equivalent all over the place (the law of one price) when interest rates and currency exchange rates are considered.
