Interest Rate Parity
Covered versus uncovered parity
Covered interest rate parity (CIP) states that the forward premium or discount equals the interest rate differential between two currencies, so that a hedged borrowing and lending strategy yields no arbitrage profit. Uncovered interest rate parity (UIP) is an expectation-based relationship: the expected change in the spot rate equals the interest rate differential. Candidates must know that CIP is enforced by arbitrage and holds closely in practice, while UIP is an empirical hypothesis that often fails in the short run.
The carry trade and deviations
Because UIP does not reliably hold, high-yielding currencies do not always depreciate as predicted, enabling carry trades - borrowing in a low-yield currency to invest in a high-yield one. Understand that CIP deviations can arise from balance sheet constraints, regulatory capital, credit risk, and liquidity, and are closely watched by central banks. The cross-currency basis is a measure of such deviations.
Traps in questions
Frequent errors: treating UIP as an arbitrage relationship rather than an expectation; forgetting to annualise rates or to use the correct day count; and confusing the direction of the forward premium with the direction of expected spot movement. Also watch for questions that assume CIP implies profitability of a carry trade - it does not.
Rule of thumb
CIP is an arbitrage condition (enforced); UIP is a forecasting hypothesis (not enforced). If a question asks what must hold to prevent riskless profit, the answer is CIP.
Worked example
Spot AUD/USD 0.6600, AUD rate 4.00%, USD rate 5.00%, one year. CIP forward = 0.6600 times 1.05 / 1.04 = 0.6663. The higher-yielding USD trades at a forward discount to AUD; a hedged AUD investor earns approximately the USD rate, not a free excess return.