Uncovered Interest Rate Parity
When the no-arbitrage condition is satisfied without the use of a forward contract to hedge against exposure to exchange rate risk, interest rate parity is said to be uncovered. Risk-neutral investors will be indifferent among the available interest rates in two countries because the exchange rate between those countries is expected to adjust such that the dollar return on dollar deposits is equal to the dollar return on foreign deposits, thereby eliminating the potential for uncovered interest arbitrage profits. Uncovered interest rate parity helps explain the determination of the spot exchange rate. The following equation represents uncovered interest rate parity.
where
- is the expected future spot exchange rate at time t + k
- k is the number of periods into the future from time t
- St is the current spot exchange rate at time t
- i$ is the interest rate in the US
- ic is the interest rate in a foreign country or currency area (for this example, following a US perspective, it is the interest rate available in the Eurozone)
The dollar return on dollar deposits, is shown to be equal to the dollar return on euro deposits, .
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