# Covered Interest rate parity vs uncovered

Hi All,

I am a little bit confused with these two terms.

In theory Covered is bounded by arbitrage (which means if a currency is undervalued every one will buy it to make a profit and it will find its equlibrium price) and uncovered is not bounded by arbtrage and prices are determined by forwards prices??

I think I am missing something, I would appreciate if someone could explain me this better and put an example with both concepts.

S

Covered interest rate parity is _ covered _: there’s a forward contract that ensures the future exchange rate, so there’s no risk.

Uncovered interest rate parity is _ not covered _: there’s no forward contract ensuring the future exchange rate, so you cross your fingers and hope: there’s risk.

Thanks S2000magician,

But my query was related to the CONDITION of the uncovered interest rate parity, the book says when it does not hold, you can FX Carry trade.

Also I do not get “when the forward rate is equal to the expected future spot rate, we say that the forward rate is an unbiased predictor of the future spot rate”

Spot exchange rates and forward exchange rates are linked. The basic trade starts when I own USD but see that EUR interest rates are higher, so want to invest in EUR denominated assets. Hence, I need to convert my USD money to EUR money at the current spot exchange rate, once there I can buy the EUR denominated asset. After the investment horizon ends, I need to go back to the former currency, USD. The risk here is that spot exchange rates can change to the extent it dilutes the differential in interest rates I saw between USD and EUR assets at the beginning.

There are 2 possible scenarios: I hedge against exchange rates unpredictable movements using forward contracts, or simply don’t hedge.

The forward contract uses a forward exchange rate that prevents arbitrage, it is calculated as follow:

F(p/b) = S(p/b)*(1+rp)/(1+rb)

where:

p : price currency

b : base currency

rp : interest rate of the price currency

rb : interest rate of the base currency

If the market forward exchange rate is not equal to the one using the above formula, then arbitrage strategies are possible by buying undervalued asset and shorting overvalued asset.

The uncovered interest rate parity states that the current difference between interest rates will push current exchange rate to change in the extent that it offsets the profit from investing in the high yield currency relative to the low yield currency.

However, this does not hold in the real world. Exchange rates does not change only by the difference in interest rates but also by other factors (a big list btw). Hence, FX carry trade can be profitable sometimes.

The forward exchange rate is an unbiased predictor of future spot exchange rates because the forward rate is set to prevent arbitrage and is not influenced by other factors just the current interest rates.

Also an important fact is that forward exchange rates despite to be the unbiased predictor of future spot exchange rates, it does not hold either. This means that the future spot exchange rates become different than forward rates most of the time. This is why getting into forward contracts does not eliminate risk completely, it eliminates uncertainty only. You can still lose or win by getting into forward contracts, another reason that feeds the FX carry trades around the world

Hope this helps.

Covered interest rate parity always holds. It has to: it’s covered.

Uncovered interest rate parity may or may not hold, and there’s no reason (well . . . not much reason) that it should.

Hi @S2000magician- in the curriculum - L3 2020 - Reading 16 - Example 7 - Cross-currency Swap- it states ‘Usually Covered interest rate parity does NOT hold and this gives rise to the ‘basis’ —> how is this possible, I assume the above comment (from another candidate/CFA holder) is correct that UNcovered AND Covered IR Parity both do NOT always hold?

It isn’t.

I discussed this quite a bit with CFA Institute, saying that they meant uncovered interest rate parity, but they insist on what they wrote. Their explanation was that counterparties might default.

It’s stupid.

Haha very clear - thanks for clearing that up!

My pleasure.