What it means
Imagine you can earn 6% on deposits in one currency and 3% in another. The theory says you should not expect an easy profit from moving your money to the higher rate.
The market expects the higher-yielding currency to lose value by about the same amount, so the extra interest is cancelled out by currency losses. The word uncovered is the key.
In covered interest rate parity the investor buys a forward contract (an agreement to exchange currency at a fixed price on a future date), so the outcome is known today. In the uncovered version there is no hedge, so the future exchange rate is an expectation and the investor carries the currency risk.
For a corporate treasurer the theory is a starting point for thinking about expected rates, but not a reliable forecasting tool. In practice, high-interest currencies have often not fallen as much as the theory predicts.
Traders have exploited this through the carry trade, in which they borrow in a low-rate currency and invest in a high-rate one. When the carry trade works, it earns the interest gap.
When it fails, a sudden currency fall can wipe out several years of gains within days. This asymmetry is one reason economists keep testing the theory and reach mixed conclusions.
Even so, the theory remains useful as a benchmark. If a treasury team plans to borrow in a low-rate currency to save interest, it should recognise that the lower rate may be offset by a currency rise that makes repayment more expensive.
Comparing the interest saving with a sensible range of exchange rate moves gives a fairer view.
In practice
Real-world examples.
Example
A treasury manager at a US exporter holds cash in dollars earning 6% while a foreign deposit earns 3%. The theory suggests the foreign currency should rise by about 3%, so shifting cash abroad should not earn extra after the currency move.
Example
A hedge fund borrows $50,000,000 in a low-rate currency and invests in a higher-rate one. If the theory held, a rise in the low-rate currency would cancel the interest gap, but the fund is betting that it will not.
Example
A finance team plans to borrow $10,000,000 abroad at a lower rate than at home. It compares the interest saving of 3% a year with the risk that the foreign currency strengthens by the same amount or more.
Formula
Calculation
Expected future spot rate = Spot rate x (1 + Domestic interest rate) / (1 + Foreign interest rate)
The exchange rate is quoted as dollars per one unit of the foreign currency. Dollar interest rates are 6% a year and foreign rates are 3%, and the spot rate is $1.03 per unit. The expected spot rate in a year is 1.03 x 1.06 / 1.03 = $1.06 per unit. The foreign currency is expected to rise by 1.06 / 1.03 - 1 = 2.91%, close to the 3% interest gap, which makes up for the lower interest earned on the foreign deposit.Case study
Seen in the real world.
Alder Components is an illustrative, fictional manufacturer that needed $20,000,000 for a new plant. A foreign bank offered a loan at 3% against 6% at home, and the treasurer considered the foreign loan because of the interest saving of about $600,000 a year.
The chief financial officer pointed out that the theory predicts the foreign currency tends to rise by about the interest gap. The company earns its revenue in dollars, so a 3% rise would increase the cost of repaying the loan by roughly the same $600,000 a year.
The illustrative decision was to take the home-currency loan for most of the funding and borrow abroad only where the company had foreign revenue. This kept the currency risk matched to its income instead of betting on the exchange rate.
Watch out
Common mistakes.
- Assuming that a higher interest rate is a free gain, when the currency may fall by enough to cancel it.
- Confusing the uncovered version with the covered version, which uses a forward contract and is much more reliable.
- Treating the theory as a forecast, when real exchange rates often do not follow it in the short run.
Questions
People also ask.
What is the difference between covered and uncovered parity?
Covered parity uses a forward contract to lock the rate and holds closely in practice, whereas uncovered parity relies on an expected rate and carries currency risk.
Does the theory work in the real world?
Evidence is mixed, because high-rate currencies have often held their value for long periods, which has allowed carry trades to earn returns.
Why does a treasurer care?
The theory shows that a cheap foreign loan may carry hidden currency risk, so the saving should be weighed against possible currency moves.
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