Uncovered interest parity

By:

Arti

Arti is a specialized AI Financial Assistant at Invezz, created to support the editorial team. He leverages both AI and the Invezz.com knowledge base, understands over 100,000... read more.

Reviewed by:

Prash Raval

Prash is a financial writer for Invezz covering FX, the stock market and investing. For over a decade he has traded spot FX full time while... read more.

Updated:  May 30, 2024

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3 min read

3 key takeaways

• Uncovered Interest Parity (UIP) suggests that the interest rate differential between two countries is equal to the expected change in exchange rates between their currencies.
• UIP implies that investors should expect to earn the same return on investments in different countries, once adjusted for exchange rate changes.
• It is based on the assumption of no arbitrage opportunities and no use of forward contracts to hedge against exchange rate risk.

What is uncovered interest parity?

Uncovered Interest Parity (UIP) is a fundamental concept in international finance that explains the relationship between interest rates and exchange rates. According to UIP, the difference in nominal interest rates between two countries should be equal to the expected change in exchange rates between their currencies. This implies that an investor should be indifferent between investing in domestic or foreign assets, as the returns, when adjusted for exchange rate changes, should be the same.

Assumptions of uncovered interest parity

UIP relies on several key assumptions:

• No arbitrage opportunities: Investors cannot earn risk-free profits by exploiting differences in interest rates and exchange rates.
• Perfect capital mobility: Investors can freely move capital across borders without any restrictions or transaction costs.
• Rational expectations: Investors form expectations about future exchange rates based on all available information.
• No hedging: Investors do not use forward contracts or other derivatives to hedge against exchange rate risk.

Implications of uncovered interest parity

UIP has several important implications for international finance and exchange rate determination:

• Interest rate differentials: Differences in interest rates between countries reflect expected changes in exchange rates. A higher domestic interest rate compared to a foreign interest rate implies an expected depreciation of the domestic currency.
• Exchange rate forecasting: UIP provides a theoretical basis for predicting future exchange rate movements based on current interest rate differentials.
• Investment decisions: Investors use UIP to assess the potential returns on foreign investments, considering both interest rate differentials and expected exchange rate changes.

Limitations of uncovered interest parity

While UIP is a valuable theoretical framework, it has several limitations in practical applications:

• Exchange rate volatility: Actual exchange rate movements can be highly volatile and influenced by factors beyond interest rate differentials, such as geopolitical events, economic data releases, and market sentiment.
• Market imperfections: Capital controls, transaction costs, and other market imperfections can prevent the free movement of capital, challenging the assumptions of UIP.
• Risk and uncertainty: Investors may require a risk premium for holding foreign assets, especially in countries with higher economic or political risk, which can deviate from the UIP condition.

Understanding Uncovered Interest Parity is crucial for analyzing international financial markets and exchange rate dynamics. For further exploration, topics such as covered interest parity, exchange rate determination, and international arbitrage provide deeper insights into the mechanisms and implications of UIP.