Covered and Uncovered Interest Parity

Interest rate parity is the relationship that links spot exchange rates, forward exchange rates and interest rates in two currencies. Its covered form says that forward rates must reflect interest rate differences, or arbitrage would be possible; it holds closely in practice. Its uncovered form says that expected exchange rate changes should offset interest differences, so investors cannot earn more simply by holding higher yielding currencies; in practice, it often fails, which is why carry trades have been profitable on average.

Covered interest parity (CIP)#

F / S = (1 + r_quote × T) / (1 + r_base × T)

Investing in the domestic currency must give the same return as converting to the foreign currency, investing there and locking in the conversion back with a forward. If not, there is a riskless arbitrage, known as covered interest arbitrage.

Before 2008, CIP held almost exactly for major currencies. Since then, small persistent deviations, measured by the cross currency basis, have appeared because of bank balance sheet constraints and demand for dollar funding. See Cross-Currency Basis.

Uncovered interest parity (UIP)#

UIP drops the forward hedge and says the expected future spot rate should offset the interest difference:

expected % change in spot ≈ interest rate difference

If US rates are 4.5 points higher than Japanese rates, UIP predicts the dollar should weaken against the yen by about 4.5% a year on average, removing any advantage from holding dollars.

The forward premium puzzle#

Many studies, starting with Eugene Fama's 1984 paper, found that UIP fails over short to medium horizons: high interest rate currencies have tended not to depreciate as predicted, and have sometimes appreciated. This is known as the forward premium puzzle. Explanations include:

• Risk premiums: high yield currencies tend to crash in global downturns, so investors demand extra return.
• Peso problems: rare large depreciations that may not appear in short samples.
• Slow moving capital and behavioural factors.

This failure is the foundation of the carry trade. See Carry Trades in Forex and Carry Factor.

CIP vs UIP#

Practical uses#

• Pricing forwards and futures: CIP gives the fair forward rate. See FX Forwards and Forward Points.
• Hedging costs: CIP shows whether hedging a foreign investment adds or subtracts return.
• Spotting funding stress: deviations from CIP signal dollar funding pressure.
• Carry strategies: UIP failures create opportunities, with crash risk.

Frequently asked questions#

What is interest rate parity?#

A relationship stating that the difference between forward and spot exchange rates equals the interest rate difference between the two currencies, so returns are equalised.

What is the difference between covered and uncovered interest parity?#

Covered parity uses forward contracts to remove currency risk and is enforced by arbitrage; uncovered parity relies on expected exchange rate moves and often fails in practice.

Why does uncovered interest parity fail?#

Possible reasons include risk premiums for crash risk, rare large depreciations and behavioural factors, which together allow carry trades to earn returns on average.

Next, learn what deviations from covered parity reveal in Cross-Currency Basis.