What does it mean when we say that uncovered interest rate parity holds?
Unconvered interest rate parity does not hold, that is the reason why forward contracts are not a good predictor of future spot rates.
However covered interest rate parity holds because if it does not hold arbitrageurs would capitalize and exploit any arbitrage opportunity and make risk-less profit.
Unconvered interest rate parity states that high yield currencies will constantly depreciate and low-yield currencies will constantly appreciate, however this is not true because if unconvered interest rate parity held, carry trade would be totally pointless and ineffective because investors cannot long the high yield currency and short the low-yield currency.
So, does it simply mean that uncovered interest rate parity is a thing that doesn’t happen in real world scenario because if it does, then arbitrageurs would capitalize on it? Is my interpretation correct?
And you mean by ‘capitalize and exploit’ is that they can trade based on the difference between the future spot rate and the locked in forward rates?
It’s not that arbitrageurs would capitalize on it. It’s that there are no economic forces that would cause exchange rates to conform to interest rate parity. Furthermore, there are economic forces that cause exchange rates to diverge from interest rate parity.
No, okay covered interest parity holds because there is an arbitrage opportunity which exists however uncovered interest rate parity does not hold primarily because
i) There does not exist an arbitrage opportunity to force equality of nominal interest rate across countries i.e an opportunity to execute simultaneous trading in two different market, so there is no opportunity to mae risk less profit.
Im doomed.
Lol, Why such gloomy comment, A problem shared is half solved.
Interestingly, I’m just finishing up an article on interest rate parity that I was going to add to Level I on my website.
This thread has convinced me that I should include it in Level II as well.