CFA CFA Level 2 What’s the deal with international parity conditions?

# What’s the deal with international parity conditions?

• Author
Posts
• rahul12
Participant
• CFA Level 3
7

hi all, first of all sorry if this question is dumb. i still can’t get my head around this nor understand the difference between:

• covered and uncovered interest rate parity
• fischer effect

any help to explain this would be much appreciated.

• cfachris
Participant
• CFA Level 3
5

Hey, I remember bitching about this back in L2. I’ve dug out and copied my notes below, hopefully I got it right….

International parity conditions shows the relationship between expected inflation, interest rate differentials, forward exchange rates, and expected future spot exchange rates, and forms the basis of our understanding of long term equilibrium value of exchange rates.

Covered interest rate parity (CIRP)
CIRP basically states that the interest rate differential between two currencies should equal the differential between the forward and spot exchange rates, so that an investor would earn the same return investing in either currency:

Fwd/Spot = (1 + i FC)/(1 + i DC), where Fwd and Spot exchange rate are expressed as Foreign Currency (FC) per Domestic Currency (DC), i = interest rate.

CIRP holds because if it does not hold, arbitrageurs would capitalize and exploit any arbitrage opportunity and make risk-less profit.

Uncovered interest rate parity (UIRP)

UIRP states that the expected movement in exchange rate should equal the interest rate differential.

E(Spot t=1)/Spot = (1 + i FC)/(1 + i DC), where E(S1) is the expected spot rate.

Key difference between CIRP and UIRP is that UIRP deals with expected future exchange rates, and expectations are not market traded, so it is not bound by arbitrage. UIRP tends to hold over the long-term but not over shorter periods, because it assumes that capital markets are efficient. And this can happen when, e.g.
capital flows are restricted or currency forwards are not available. CIRP on the other hand is based on arbitrage.