Uncovered vs. Covered interest rate parity

They seem to be the same (same formula). Why would one use one or the other? Can someone explain the difference in the simplest way possible (without saying one is priced into forwards and one isn’t)?

In covered interest rate parity, the value is ensured by a derivative (a forward contract).

In uncovered interest rate parity, the value is hoped for (i.e., fingers crossed).

The fact that uncovered exchange rates don’t always follow interest rate parity (i.e., that uncovered interest rate parity doesn’t always work) is the reason people exploit carry trade. (Note: when UIRP does hold, those who have carry trade positions – especially levered positions – lose big time.)

Interesting, it is like the USD/Yen carry trade… Is there a reason why it never converges? Interesting that investors would take this risk in the carry trade.

In covered interest parity , Interest differential should be matched by forward rate and spot rate . Where as In the uncovered parity It should be matched by spot rate and Expected spot price in future.

I struggled with this too. My interpreration is that uncovered interest rate parity generally refers to markets where there are capital controls or illiquid forward markets. As such, there is no forward rate product that exists which would force interest rate parity.

Uncovered interest parity doesn’t hold in the real world and is one of the great “paradoxes” of economics. Just remember that theoretically it should hold.

Best explanation ever :slight_smile: