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ECONOMICS

Uncovered Interest Parity  (UIP)

By: CIFER | Updated Mar 27th, 2021

Similarly to Covered Interest Parity, UIP acknowledges the relationship between interest rates and the foreign exchange market: The theory states the interest rate differentials will equal the relative change in currency valuations over the same period. The difference between UIP and CIP is in the forward currency markets; CIP includes forward rates in its condition and strategies developed around the condition will be covered (hedged) against foreign exchange exposure, where as UIP uses estimated (PPP) forward rates leaving exposure in the strategy.  

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INTERPRETING UIP:

Uncovered interest parity is related to 'the law of one price', an economic theory that underpins the currency concept of purchasing power parity (PPP). The principles in theory state the basket of goods, or in this case financial securities, should be priced identically once adjusted for currency values leaving no opportunity for arbitrage. UIP condition is satisfied when:

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Where            is the expected future spot rate and         is the current spot rate

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As the UIP condition assumes the foreign exchange market is in equilibrium, implying that the expected return on foreign and domestic assets are equal once adjustments have been made for relative currency valuations, if the domestic interest rate is higher than the foreign interest rate, the depreciation in the domestic currency would rebalance the market at equilibrium. 

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The assumption of risk-neutrality (traders only care about returns and not risk), is the same as assuming foreign and domestic assets are perfect substitutes. As such traders only care about asset prices and are indifferent between foreign and domestic assets if:

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In the case of being risk-adverse, the assets are imperfect substitutes and traders require a premium for holding the riskier asset, as such, the market equilibrium will be:

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USING YIELD CURVES

In reality there is no such thing as the interest rate for a country as rates vary between instruments and the time to maturity. Term structure of interest rates (yield curves), can signal short term moves in interest rates but also how the market expects the exchange rates to change. For example, assume that UK and US assets are imperfect substitutes and investors are risk neutral, we can show how the yield curves give an indication as to the expected exchange rate. 

With an exchange rate of $1.5/£, US rates at 4.5% and UK rates of 1.5%, we can us UIP to estimate how much the exchange rate might move as a result of higher foreign yields.

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We can re arrange the parity condition (above) so that:

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The 12-month future estimated exchange rate based on the yield curves is $1.4569/£. 

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Note: Hypothetical indirect exchange rate quotes were used assuming sterling to be the domestic currency.

LIMITATIONS OF UIP

The literature on the theory is not particularly well supported in the short run, with empirical evidence showing the exchange rate change was often less than predicted by UIP, sometimes the complete opposite. However, UIP remains widely practiced among economists, analysts and academics 

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THE FORWARD PREMIUM PUZZLE

Empirical testing of UIP often finds the beta coefficient <1. This implies that the forward premium/discount tends to overstate the realised appreciation/depreciation; an empirical regularity otherwise known as the 'forward premium puzzle'.

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When the forward market exchange rates are higher than the current spot rate, the foreign currency is at a forward premium but the realised appreciation in the currency tends to less than predicted by the premium (or the interest rate differential).

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Currency Carry Trade

A currency carry trade is a widely used speculation strategy motivated by the forward premium puzzle. The puzzle implies that it would be profitable to sell forward currencies that are at a forward premium (low yielding currencies) and buy forward currencies that are at a forward discount (high yielding currencies). The strategy is equivalent to borrowing low interest yielding currencies to lend in high interest yielding currencies, without hedging the associate exchange rate risk.

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Example;

Using the same figures as above, a trader could borrow in sterling at 1.5% and convert to US dollars where the capital would yield 4.5% for a potential profit equalling the interest differential of 3% (pre transaction costs). However, this type of strategy is unhedged and exposed to volatile exchange rate moves. Leveraged positions would be at increase risk and would need much less than the 3% change in currency valuations for the trade to result in a loss. Shifts in Monetary policy sentiment or times of uncertainty could result in position being unwound and drastic changes in currency values.

 

Covered interest parity follows similar principle however is fully hedged against exchange rate exposure. 

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