Why do we assume in the UIRP that investors are risk neutral? can someone explain it please?
In covered interest rate parity you have exchange rate forward contracts. Those forwards assure a established exchange rate (one year from now for example) which the invested funds will be returned to the original currency. The forward exchange rate is calculated using the risk-free rates of both currencies involved. Hence, the profit that could arise from the difference of interest rates (of foreing and local currencies) is zero. This is true because the forward exchange rate prevents arbitrage (the difference of interest rates, hence a profit)
So how could we profit from a strategy of borrowing in one currency that lends at 2% interest and then exchange that currency into another that pays 10% interest?
Simply don’t use a forward contract.
The risk here is what the spot exchange rate will be at the end of the investment period. If the currency that I borrowed depreciates against the investment currency more than 8% (10% - 2%), I will lose money at the end of the investment period. This risk is unhedged (no use of forward contracts), so the investor is able to earn a profit but also bear loses. This is why the investor must be risk-neutral in order to be willing to invest in Foreing Exchange Carry Trades.
Hope this helps!
A risk neutral party is indifferent between choices with equal expected payoffs even if one choice is riskier.
I cant see that this is the case here.
In this carry trade example, he can get more than 8% when the borrowing currency appreciates against the investment currency, so the expected payoff here is practically unknown (nobody can predict exchange rates movements easily). However this investor could calculate a “expected return” with the info available he has that moment. He compares this expected return with other expected returns (which must be equal of the carry trade right?), but he decides to make a carry trade anyways. He is dreaming about that 22% profit he could get if the exchange rate appreciates 14% instead of 0% despite he could get a guaranteed 4.5% return on a AAA bond. This is risk neutral, isn’t it?
Since you asked about uncovered, UIRP assumes forward FX rates will be no different than = spot price less PV of cash flows (i.e., base Rf yield) compounded at the price Rf rate (i.e., Rf yield). This is like most other futures/forward contracts in the CFA curriculum. But this assumes risk-neutrality, and, in actuality, FX investors (like all investors) are likely risk-averse, so in addition to compounding at the price currency’s Rf rate, they will demand a risk premium based on other perceived risks, which will create a different future FX rate than UIRP would have us predict.
I think that’s why UIRP is used as the jumping-off point when teaching FX.
Thanks gents. Very well cleared