Page 9 - FINAL CFA II SLIDES JUNE 2019 DAY 4

‘Uncovered’ Interest Rate Parity (not bound by READING 11: CURRENCY EXCHANGE RATES: UNDERSTANDING EQUILIBRIUM VALUE
arbitrage): Arbitrage forces the FR to a level
consistent with the difference between the two
country’s nominal interest rates (If forward MODULE 11.2: MARK-TO-MARKET VALUE, AND PARITY CONDITIONS
contracts are not available, or if capital flows are
restricted so as to prevent arbitrage, the Say A/B, B is expected to appreciate by R – R . (When R – R = -Ve,
A
B
B
A
relationship need not hold). B is expected to depreciate). Mathematically: E(%ΔS) (A/B) = R – R B
A
EXAMPLE: Forecasting spot rates with uncovered interest rate parity: Suppose ZAR/EUR = 8.385. The 1-year nominal rate in the
eurozone is 10% and it is 8% in South Africa. Calculate the expected percentage change in the exchange rate over the coming year
using uncovered interest rate parity.
Answer: ZAR interest rate is less than the euro interest rate, so uncovered interest rate parity predicts that ZAR will appreciate because of
higher interest rates in the eurozone. Euro expected to “appreciate” by approximately R ZAR – R EUR = 8% – 10% = –2%.

(Note the negative 2% value.) Thus the euro is expected to depreciate by 2% relative to the rand, leading to a change in
exchange rate from 8.385 ZAR/EUR to 8.217 ZAR/EUR over the coming year.

Covered interest rate parity (CIRP) Uncovered interest rate parity (UCIRP)

Derives the no-arbitrage forward rate Derives the expected future spot rate (which is not market traded).

Assumed by arbitrage Not assumed by arbitrage

If the foreign interest rate is higher by 2%, the foreign currency is expected to depreciate by 2%, so the investor
should be indifferent between investing in the foreign currency or in their own domestic currency. Hence,
uncovered interest rate parity assumes that the investor is risk-neutral.

If FR = EFSR (expected future spot rate), then FR is an unbiased predictor of the future spot rate (F = E(S ); this is called forward rate
1
parity. In this special case, if CIRP (and it will; by arbitrage) UCIRP would also hold (and vice versa).
Stated differently, if UCIRP holds, forward rate parity also holds (i.e., the forward rate is an unbiased predictor of the future spot rate).
There is no reason that UCIRP must hold in the short run, and indeed it typically does not.
It does generally hold in the long run, so longer-term, EFSR based on UCIRP are often used as forecasts of future exchange rates.