covered tells you that expected change in exchange rates equal changes in interest rates. and uncovered is same thing but it claims that i does not always hold exactly? can anyone add some more meat to this, thanks.
Covered is reasonable because it deals with forward rates which are market prices, no guesswork required. Uncovered uses *expected* exchange rates which are only a guess.
what is the diff between forward rates and expected future spot rates? this always confuses me…they should be the same if theres no arbitrage right? i assume that forward rates are the “contract” rates that you enter that must not move whereas expected spot rates are what we assume they will be based on economic conditions?
Yes, you got that.
ok so in the IRP formula, when we do S x (1+i)/(1+i), is the result equal to F for covered and E(S) for uncovered?
My understanding is that covered IRP is enforced through arbitrage. If it didn’t hold, there would be a big profit to be made today, and all the profit-taking would push the rates back into alignment immediately. Uncovered IRP is more of an academic relationship, predicting what spot rates SHOULD be in the future. But there is no way to lock in that rate today–you have to wait until the future to do a deal at the future spot rate. A forward rate is a rate that you could lock in today, for settlement in the future.
Only if real interest rates are same (suspect), and if PPP holds (suspect).
so does that mean that we would not be expected to calculate expected spot rates…i just dont have my econ book with me and i dont remember if in the uncovered formula if the result (left side of the equation) is expected spot or if its forward rate
I meant to say that only if real interest rates are same (suspect), and if PPP holds (suspect), that the two are the same.
I don’t have the book either, but I’m pretty sure uncovered IRP gives the expected spot rate.