Uncovered vs Covered IR parity.

CFA Level II Economics
#1

Hi Everyone,

I went over this months ago, and now I am confusing Covered and Uncovered IR Parity.

I remember that covered meant Hedge & uncovered not, but I don’t find the difference obvious. I re-read the section about it in the book, and I am even more confuse! :frowning:

Would you have a simple way to dissociate the 2?

Thanks in advance,

#2

Covered means you’re indifferent between going long an interest rate in currency A and Currency B because investing in either yields the same return. You go long the currency and hedge with a forward, or vice versus.

Uncovered means the same above yet you do not hedge with a forward but you still expect to earn the same yield in either currency. Even though you’re not hedged, you expect other market participants to used arbitrage to remove any price/return differences between the two currencies.

#3

Covered interest rate parity relates the forward rate (covered – ensured – by a forward contract) to the current spot rate. Uncovered interest rate parity relates the expected spot rate to the current spot rate. The relationships are the same, but they’re being applied to different variables.

#4

thank you, guys

to S2000Magicien, your website rocks !!

#5

You’re welcome.

Thanks. It’s only going to get better.

#6

Dear all, I believe somewhere is wrong on my interpretation of interest rate parity. Please correct me. Base on the parity, currency of the nation that implement low interest rate will appreciate relative to that of nation that implements high interest rate. which means, I will just implement monetary expansion to print infinite money supply while not lose any currency value but appreciate it.

#7

There are multiple forces that affect exchange rates; interest rate parity is but one of them. Purchasing power parity is another, and your monetary policy will affect that. In spades.