Covered vs. uncovered interest rate parity

Written by sam grover
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Covered vs. uncovered interest rate parity
The occasional lack of interest rate parity can be used to make risk-free returns. (money money money image by Tribalstar from Fotolia.com)

In a nutshell, interest rate parity is the market's tendency to correct itself against arbitrage---the purchase and sale of an asset in two separate financial markets in order to profit from a price difference between the two. It describes the relationship between forward exchange rates, spot exchange rates, and interest rates between two countries.

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Exchange Rates

A forward exchange rate is when an investor agrees to exchange his money at a certain rate at a certain point in the future; a spot exchange rate is the exchange rate right now.

Covered Parity

Under covered parity, there is no incentive to borrow money from, say, the United States, convert it to Canadian dollars while entering a forward exchange agreement, then loan it to Canadians at higher interest rates because the difference between the forward and spot rates would be the same as the difference between the two interest rates.

Uncovered Parity

Uncovered parity does not use forward exchange rates, but rather the expected change in spot rates. For there to be potential for profit, the interest rates must be higher than the expected change in profits. Uncovered parity uses estimates rather than actual contract prices, so exploiting the lack of it is riskier.

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