There is no logic behind Covered & Uncovered Interest Rate Parity

CFA Level II Economics
#1

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

#2

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.

#3

  1. If covered interest rate parity does not hold, that would give rise to an arbitrage opportunity. So it has to to hold, irrespective of any factor.

  2. Uncovered interest rate parity states that the expected change in spot price is suggested by the levels of interest rate. But in most cases the expected rates are not realized, giving rise to carry trade profits. Bottomline Uncovered interest rate parity need not hold.

#4

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”.

#5

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?

#6

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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#7

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

#8

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

#9

http://finexamhelp123.wpengine.com/covered-interest-rate-parity-irp-pricing-currency-forwards/

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#10

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

#11

Cool!

My pleasure.