UNCOVERED INTEREST RATE PARITY (UIP)

Definition

Uncovered Interest Rate Parity (UIP) is an economic theory that states:

The difference in interest rates between two countries is equal to the expected change in their exchange rates over the same period.

Unlike covered interest rate parity (CIP), UIP does not use forward contracts to hedge currency risk—hence the term uncovered. It assumes that investors are indifferent between domestic and foreign investments once expected currency movements are taken into account.

Origins

• "Parity" stems from the Latin paritas, meaning equality.
• The idea traces back to early international finance theory in the 20th century, expanding on the law of one price and the efficient market hypothesis.
• UIP became formally popularized in academic literature in the 1970s–80s, particularly in studies linking exchange rate expectations with capital flows.

Usage

• Forex markets – Explains why high-yield currencies may depreciate over time.

• Monetary policy – Links interest rate changes to currency expectations.

• Global investing – Assists in comparing foreign vs. domestic investment returns.

• Risk premium studies – Measures deviations from UIP in carry trade profitability.

How UIP Works

The UIP condition says:

1. If a foreign country’s interest rate is higher than the domestic interest rate…

2. The foreign currency is expected to depreciate against the domestic currency…

3. So that expected returns (adjusted for FX changes) are equalized between the two countries.
   
   

Types of Interest Rate Parity

• Covered Interest Rate Parity (CIP) – Uses forward contracts to eliminate currency risk.

• Uncovered Interest Rate Parity (UIP) – No hedging; relies on expected spot rates.
  
  

Key Takeaway

• UIP is theoretical, empirical evidence often shows deviations (the “forward premium puzzle”).

• If UIP held perfectly, carry trades would yield zero excess returns.

• It assumes risk neutrality and rational expectations in FX markets.

Context in Financial Modeling

• FX forecasting models – UIP can be used as a baseline for exchange rate expectations.

• Global portfolio returns – Incorporates expected FX movements into ROI.

• Risk-adjusted return analysis – Measures the gap between UIP-predicted returns and actual returns.
  
  

Nuances & Complexities

• Risk Premium – Real markets demand extra returns for taking currency risk, so UIP often fails empirically.

• Short-term deviations – UIP tends to work better over the long term.

• Behavioral factors – Investor biases can cause persistent mispricing.

• Market frictions – Transaction costs, capital controls, and illiquidity distort UIP relationships.
  
  

Mathematical Formulas

$$E\left( \frac{S_{t+1} - S_t}{S_t} \right) = i_d - i_f$$

Where:

• $S_t$ = Current spot exchange rate (domestic currency per unit of foreign currency)

• $S_{t+1}$ = Expected future spot exchange rate

• $i_d$ = Domestic interest rate

• $i_f$ = Foreign interest rate
  
  

Or equivalently:

$$E(S_{t+1}) = S_t \times \frac{1 + i_d}{1 + i_f}$$

Related Terms

• Interest Rate Parity (IRP)

• Covered Interest Rate Parity (CIP)

• Carry Trade

• Forward Premium Puzzle

• Exchange Rate Expectations

Real-World Applications

Example 1: FX Forward

An importer agrees to buy €1M in 90 days at $1.10/€, protecting against euro appreciation.

Example 2: Commodity Forward

A wheat producer locks in $6.50/bushel for a harvest due in six months, eliminating price uncertainty.

Example 3: NDF

A company operating in a restricted currency market (e.g., INR/USD) uses an NDF to hedge without physical currency delivery.

References & Sources

• Quickonomics: Uncovered Interest Parity