Economics: Uncovered rate parity doubt.

Hi all.

According to uncovered rate parity the higher interest rate currency should depreciate in relation to lower interest rate currency.

To me this makes no sense.

If USD is 3% and RUB is 8% then shouldn’t I start buying RUB and selling USD? So the FX should go the other way around!

Extra: Am I the only one who thinks Schweser notes are extremely superficial for CFA2? They just say what amd not why, I am reading economics and have no clue what I am reading!

Hi,

High yield currency should depreciate against low yield currency, if this not happen, there is an arbritrage opportunity by:

  1. Get a loan in The low yield currency.

  2. Convert The loan proceed into The high Yield currency

  3. Invest in the high yield currency (IE. Time deposit)

  4. At maturity, convert The proceed from investment (interest and principal) into low yield currency.

  5. Pay The loan, and get The profit from arbitrage (without investisting your money)

P.D for me Kaplan is good, but you have to practice EOC’s, from CFA curriculum

Sorry, The way you profit in uncovered interest rate parity is by “Carry Trade”(that is The example I wrote in The Other comment), arbitrage is when there is an active market for The underlying asset.

Interest rate parity does not drive exchange rates.

What do you mean??? They do!!

How? What’s the mechanism?

If the USD 1-year rate is 2% and the GBP 1-year rate is 1.5%, what economic fundamentals will drive the USD/GBP exchange rate higher?

Consider this: suppose that:

  • On 1/1/20 the 1-year USD risk-free rate is 2%, the GBP 1-year risk-free rate is 1.5%, and the USD/GBP exchange rate is 1.2861
  • On 7/1/20 the 6-month USD risk-free rate is 1.5%, the GBP 6-month risk-free rate is 2%, and the USD/GBP exchange rate is 1.2861

On 1/1/21, which IRP (1/1/20 or 7/1/20) will win and which one will lose?

How? What’s the mechanism?

If the USD 1-year rate is 2% and the GBP 1-year rate is 1.5%, what economic fundamentals will drive the USD/GBP exchange rate higher?

S2000Magician,

Would it have to do with current account balances?

Hi,

there is Covered “Interest rate parity” and Uncovered “Interest Rate parity”

Covered (active market for The currency pair) states that

forward rate = spot rate (1+rp)/(1+rb)

rp = Interest rate on price currency

rb = Interest rate on base currency

if The relationship does not hold, there will be arbitrage opportunity so eventually The relationship will be bound by arbitrage.

Uncovered (no active market for currency pair)

states that “The high yield currency “should” depreciate against The low yield currency for no carry trade (arbitrage) opportunity

change % in spot (A/B)= Interest rate A - Interest rate B

so, regarding your example:

Suppose

if USD interest rate 1Y is 2% and GBP interest rate is 1Y 1.5% and the spot exchange rate is 1.286 USD/GBP

The change in spot rate should be:

2% - 1.5 = 0.5% (note that the dollar should depreciate against the GBP)

the high yield currency should depreciate 0.5% against the low yield currency

that’s a “expected spot rate one year later of”

1.286(0.005) = 0.00643 + 1.286 = 1.2924 USD/GBP

CARRY TRADE

fund (loan in low yield currency) = 100 GBP

convert into USD (high yield) = 128.6 USD

Invest (128.6 @ 2%)

in one year.

Investment return = (128.6 * 1.02) = 131.17 USD

convert to GBP = 131.17/1.2924 = 101.50GBP

pay The loan

Interest = 100 * 0.015 = 1.5

principal = 100

profit = 0

if The relation does not hold there would be a profit (it may not hold but historically the distribution has excess kurtosis and negative skewness, so probability of loose is higher than the prob of profit)

I don’t know what’s the exact mechanism in uncovered interest rate parity, could be balance of payments one of many factors

I’m not aware of any reason that uncovered interest rate parity should hold, but I haven’t given any thought to current account balances.

Covered interest rate parity has one job and one job only: to prevent arbitrage. It’s not trying to predict future exchange rates.

You’re right, uncovered interest rate parity may not hold, is a bet.

And the “mechanisms” that can help determine long run exchange rate are as follows:

1 Supply / Flow Demand Channel

2 Portfolio Balance Channel

3 Debt Sustainability Channel

And to Julio77’s earlier point regarding interest rates:

see page pg 580-82 CFAI reading 11