The uncovered interest rate parity (UIP) is a parity condition stating that the difference in interest rates between two countries is equal to the expected change in exchange rates between the countries' currencies. If this parity does not exist, there is an opportunity to make a risk-free profit using arbitrage techniques.

Assuming foreign exchange equilibrium, interest rate parity implies that the expected return of a domestic asset will equal the expected return of a foreign asset once adjusted for exchange rates. There are two types of interest rate parity: covered interest rate parity and uncovered interest rate parity. When this no-arbitrage condition exists without the use of forward contracts, which are used to hedge foreign currency risk, it is called uncovered interest rate parity.

The formula for uncovered interest rate parity takes into account the following variables:

Uncovered interest rate parity (UIP) theory states that how the interest rates differ between two countries will be the same as the relative change in currency foreign exchange rates over the same timeframe. It is one form of interest rate parity (IRP) used with covered interest rate parity.

There are two forms of Interest rate parity: uncovered interest rate parity involves not covering exposure to foreign exchange risk (unanticipated changes in exchange rates), whereas covered interest rate parity involves using a forward contract.

espot(t)(1+iDomestic)= Et[espot(t+k)](1+iForeign), where: Et[espot(t + k)] represents the expected value of the spot exchange rate. espot(t + k), k periods from now. ... k represents number of periods in the future from time t. espot(t) represents the current spot exchange rate. iDomestic represents the interest rate in the country/currency under consideration.

The condition for interest rate parity to hold in a fixed exchange rate system is that the interest rates between two countries must be the same.

Economists have been able to prove that covered interest rate parity generally holds, although not precise because of the effects of various risks, costs, taxation, and ultimate differences in liquidity.

It does not hold because of difference in exchange rates. In covered interest rate parity, the difference between interest rates gets adjusted in the forward discount/premium but investors do not have this benefit in an uncovered interest rate parity.

Covered interest rate arbitrage uses favorable interest rate differentials to invest in a higher-yielding currency, and offsets the exchange risk through a forward currency contract.

www.nber.org [PDF]

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www.aeaweb.org [PDF]

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www.sciencedirect.com [PDF]

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www.sciencedirect.com [PDF]

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www.sciencedirect.com [PDF]

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www.sciencedirect.com [PDF]

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www.sciencedirect.com [PDF]

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academic.oup.com [PDF]

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