Covered and uncovered interest rate parity

I’m having a hard time understanding the difference between the two and the answer to the following question in this year Wiley mocks.

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“The manager believes that inefficiencies occur in the foreign exchange markets that can be exploited** to generate excess return consistently over the long term. One of the major strategies that we have been employing successfully over the past few years is exploiting forward rate bias through the carry trade executed in currency forward markets.”**

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Based on the notes made by Guscott about management of the GEIG Fund, it is most likely that the fund is profiting from which of the following parity relations not holding?

A. Covered interest rate parity. B. Uncovered interest rate parity. C. Purchasing power parity.

Answer: B

Uncovered interest rate parity is a theory that predicts that high interest rate currencies should weaken such that investors get the same returns regardless of the currency their deposits are held in. If this theory held, then the carry trade, which involves depositing in high‐interest‐rate currencies and borrowing in low‐interest‐rate currencies, would never work since interest rate differentials would be offset by foreign exchange rate movements. Answer A is incorrect since covered interest rate parity is a no‐arbitrage law for pricing futures contracts and hence is not used to predict where exchange rates will move to. Answer C is incorrect since purchasing power parity predicts that exchange rates are driven by inflation differentials.

Covered interest rate parity incorporates a contract (e.g., a futures contract, or a forward contract) to ensure interest rate parity.

Uncovered interest rate parity incorporates crossed fingers to ensure interest rate parity.

Covered interest rate parity always holds.

Uncovered interest rate parity rarely holds.

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Thank you S2000magician for taking the time to answer us.

It seems though, that the manager is using currency forward contract. So I’m wondering why the answer is not the “covered interest rate parity” ?

Carry trade specifically does not incorporate a forward/futures contract. You’re hoping to make money when the future exchange rate differs from the IRP exchange rate.

If covered interest rate parity holds during FX carry trades, and the higher interest rate currency (investing currency) depreciates the level of the interest rate differential, than the trade will not produce any gains. In FX carry, you borrow at the interest rate that is trading at a forward premium (F0>S0) and invest in the currency trading at a forward discount (F00) - i.e. borrow at lower rate currency and invest in higher rate currency.

Because they are profiting, the UIRP isn’t holding (i.e. the currency appreciates, maintains a consistent spot rate, or depreciates less than implied by UIRP). That’s what is required for the FX carry trade to profit. If the investing currency depreciates more than the UIRP, there can be substantial losses.

S2000, clean me up here if I was off!

You got it, PreDRaR66.

My only complaint is the beginning of your first sentence: " If covered interest rate parity holds . . . ." CIRP always holds. There’s no “if” about it.

Oops - that was supposed to say UIRP holds. Quick typing got the best of me.