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Uncovered Interest Rate Parity (UIP)

Candlefocus Editor
Uncovered interest rate parity (UIP) is an economic concept that states the relationship between the interest rates of two countries and their corresponding exchange rates. It is a hypothesis used by economists that was introduced by the late Nobel prize winning economist, Jagdish Bhagwati in the 1950s. The theory is based on the premise that if investors wish to capitalise on higher interest rates around the world, they will buy more of the currency with a better rate and sell the one with a lower rate.

UIP assumes perfect competition in a market with unrestricted international capital flows, and in practice, it helps explain and predict real-world exchange rate behaviour. UIP helps to explain differences between real and expected exchange rate movements, and it is also useful for traders, investors, and analysts.

The equation for UIP, or the concept of ‘no-arbitrage’, is generally expressed as:

Exchange Rate = (1 + Domestic Interest Rate)/(1 + Foreign Interest Rate)

The formula suggests that the domestic currency spot rate is equal to expected future spot rate multiplied by the ratio of domestic risk free one-period interest rate to the foreign risk free one-period interest rate.

UIP works as a kind of arbitrage mechanism. It means, for example, that if the Japanese Yen is yielding higher interest rates than the US Dollar (USD), currency speculators would be incentivized to sell Yen and buy USD. The surge in the demand for USD, in turn, would cause the exchange rate to shift until the interest rates of both countries are equal. A loss of the difference in expected return would occur in the process, which encourages investors to avoid opportunities related to arbitrage.

In a nutshell, uncovered interest rate parity is an important economic equation that states the relationship between domestic and foreign interest rates and their corresponding exchange rates. By using UIP, traders, investors, and economists are able to better understand foreign exchange markets and make more informed decisions in terms of investing and trading.

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