HI,
can anybody tell me the difference between the Covered Interest parity & uncovered interest rate parity.
The Uncovered IRP is not bound by arbitrage, in another word, you cann’t trade based on this relationship, so it can give you an expected exchange rate E(S), which may not hold.
The Cover IRP is traded on the relationship of the interest rates, so it has to be arbitrage free and calculates the forword rate F(t).
The Uncovered IRP is not bound by arbitrage, in another word, you cann’t trade based on this relationship, so it can give you an expected exchange rate E(S), which may not hold.
The Cover IRP is traded on the relationship of the interest rates, so it has to be arbitrage free and calculates the forword rate F(t).
Or simply put it, covered means that there is a forward rate obtainable (where forward rate is based on the current spot rate and the interest rate differential). While uncovered means it just based on expectations for future spot rates.
Uncovered IRP means that you can’t hedge your currency risk by buying a forward contract.
Remember, if you have to pay 1 million Euros in one year, you might want to buy a forward contract on the euro so that you can be assured you get the Euros at a known rate, instead of being shocked to find that the Euro has appreciated considerably. What uncovered IRP is saying is that the expected spot rate in the future is nothing but the current rate times the inflation rate differential. But that’s what the forward rate is! Well that’s weird! It means if I go ahead and buy the forward contract to lock in the rate (thinking that you’re smart by hedging your risk), you will find that a year later, the spot rate is the same as the rate that you thought you locked in.
So, there is no advantage to buying the forware contract, and there is no way to hedge your risk. However, it is known that Uncovered IRP is not realistic, lucky for hedgers. For it to be realistic, real interest rates have to be the same all over the workd, *and* PPP must hold, both of which are not really true. The covered IRP does not make that assumption. It is considered realistic.
The international Fisher Relation deals with how nominal rates of return are nothing but real interst rates times inflation, so that the difference between the nominal rates of return in two countries is approximately equals the difference between their inflation rates. So, if you invest in Brazil versus investing in the U.S., there is no difference! In the end the return difference is due to inflation, which then kicks you back when you convet to U.S. dollars. Again that is only true if uncovered IRP is true.