Hi guys,

In the real world, we would expect that when a central bank of a particular country raises interest rates, that country’s currency starts to appreciate, much like the US dollar has appreciated ever since the Fed started raising rates since December 2017.

Why then, does the Covered and Uncovered Interest Rate Parity state that the currency with the higher interest rate should trade at a forward discount and a lower expected spot price in the future, (respectively for Covered & Uncovered).

Regards

Covered interest rate parity has to hold. And it has nothing to do with future spot prices.

There’s no reason for uncovered interest rate parity to hold.

What do the words “covered” and “uncovered” mean in this context?

For simplicity, one could say or think “interest rate parity” & “interest rate non-parity”.

I just found this: “UIRP means that interest rates and exchange rates will adjust…”

So the “uncovered” theory allows for rates to fluctuate, whereas the “covered” theory does not?

Covered simply means that you have the future rate locked in by a contract. That’s between only you and your counterparty; it tells you nothing about what the market does.

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In the covered interest rate parity formula, why is the Forward dc/fc / Spot dc/fc in the Numerator position, and not the Denominator?

Perhaps for F/S = (1+R d/c) / (1+R f/c), this would be rate parity.

The lightbulb just came on, thank you for the clarity.