For some reason I can’t wrap my head around these concepts. Can anybody dumb these down for me and explain the differences?
Thanks!
Uncovered interest rate parity says that the expected future exchange rate follows interest rate parity, and covered interest rate parity says that forward rates follow interest rate parity.
Uncovered interest rate parity matters only in the absence of forward contracts.
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Covered interest rate parity is an arbitrage relation that states that forward exchange rates are a function of current spot rates and interest rates in each currency. Essentially it says that you can’t profit by borrowing in one currency and investing in another over a period because the forward rate you would lock in would exactly offset the changes in value due to the different interest rates. It is an arbitrage reltiaon because you know all factors at the present time, you know the current spot rat, you know the interest rates for each currency and you can lock in a price with the current forward rate.
Uncovered interest rate parity has nothing to do with forward rates, it is forecasting EXPECTED FUTURE SPOT RATES. It states that the expected future spot rate is a function of the current spot rate and the interest rates of each currency. It is not an arbitrage relation because you cannot lock in the future spot rate at the present time.
You’ll notice that they are pretty much the same thing, and if the forward rate is an unbiased predictor of the future spot rate then they are the same thing. The critical difference is that covered parity uses forward rates you can lock in TODAY and uncovered forecasts the spot rate that will occur at time T.
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From Kaplan:
And this is from my Kaplan formula Quicksheet:
Now, my question relates to the Uncovered Interest Rate Parity formula. We solve for E, hence isolate E. But what is the variable in the formula that represents the current spot exchange rate 0.5500? If it’s on the left side of the equals sign, then when I move it to the right side, wouldn’t it serve as the dividend, and not be used for multiplication?
Um . . . E isn’t a variable or unknown.
It’s an operator.
E\left(\%\Delta S\right) means the expected percent change in the spot rate.
Got it. Then it’s E(%∆S) multiplied with the current spot exchange rate = the E spot rate in one year.
Do we apply the same formula when solving for Uncovered Interest rate parity versus solving for Covered Interest rate parity?
I can answer my own question. No we do not. It appears to calculate the uncovered interest rate parity, we find the Difference in the Foreign and Domestic risk free rates. Then multiply the given spot exchange rate by the Difference.
New question: When Uncovered Interest rate parity is involved, does that always mean we will be solving for the Forward exchange rate?
New question: When Uncovered Interest rate parity is involved, does that always mean we will be solving for the Forward exchange rate?
Not necessarily.
I’ve seen practice questions in which they give you the forward rate and you have to solve for the spot rate.
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That is what I thought.