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Covered and Uncovered Interest Parities What is CIP? Covered Interest Parity (CIP) is a no-arbitrage condition which states that the forward premium of a foreign currency should be equal to the interest rate differential between a domestic asset and a substitutable foreign asset. CIP implies the equ...

Covered and Uncovered Interest Parities What is CIP? Covered Interest Parity (CIP) is a no-arbitrage condition which states that the forward premium of a foreign currency should be equal to the interest rate differential between a domestic asset and a substitutable foreign asset. CIP implies the equality of returns on comparable financial assets denominated in different currencies. The underlying mechanism for CIP is covered interest arbitrage. CIP requires perfect capital markets : ● All participants have equal and costless access to information : they share homogenous expectations about futures outcomes ● All buyers and sellers cannot individually influence prices : they are price takers. ● No transactions costs, no taxes, no barriers to trade ● Complete certainty : no execution risk in simultaneous transactions, no limit to the supply of arbitrage fund, no default risk, no country risk. What is Covered Interest Arbitrage? Covered interest arbitrage is the transfer of liquid funds from one monetary center to another to take advantage of higher rates of return or interest, while covering the transaction with a forward currency hedge. Suppose the 3-month T-bill rate in the U. S. is 12%, higher than the 3-month T-bill rate of 8% in Canada. Attracted by the higher interest rate, investors would tend to change their Canadian dollar into U.S. dollar and invest their funds in the U.S. Simultaneously, they buy contracts to sell dollars in 3 months in the forward market. If the spot exchange rate is 1.00CAD/USD at present, and the 3-month forward exchange rate is 0.99CAD/USD at present, then the investors' losses in exchange conversion will be 1%. From the interest rate differential, they will earn 1% in 3 months (since annually they earn (12%-8%)=4% by investing in U.S. rather than in Canada). This profit is just offset by the loss. However, if the interest rate in U.S. is higher, making the earning in interest rate differential much larger in absolute value than the loss in foreign exchange, this arbitrage process will continue. Then, large amount of funds flow from Canada into U.S., putting pressures for U.S. to lower its interest rate and for Canada to raise its interest rate. In addition, the increasing demand of U.S. dollar in the current market tends to raise the spot rate for U.S. dollar. The increasing demand of Canada dollar in the forward market tends to decrease the future rate for U.S. dollar. The process continues until returns from investing in the two countries reach the same level. Then the CIP conditions will be satisfied again. How can we explain deviations from CIP? Academically, the empirical deviations from CIP are always explained as violations to the assumption of free capital flow and the substitutability of assets from different countries. The possible explanations include: 1. There may be transaction costs, which introduces a "transaction band" into the CIP equation. Recently, Cody (1990), Moosa (1996) and Balke and Wohar (1998) studied about the relation between CIP and the transaction costs. 2. There may be possible capital controls, which actually adds costs to the investment in other countries and creates similar effects of the transaction costs to the CIP equation. 3. There may be difference in tax rates on interest income and foreign exchange losses/gains in different countries. This difference contributes to the non-substitutability of investments in different countries and makes investment in a country more preferable than the other. What is UIP? UIP states that if funds flow freely across country boarders and investors are risk neutral, after the adjustment of expected depreciation, the expected rates of return to substitutable assets denominated in different currencies should be equal. In equation, it is expressed as the equality between the expected changes in spot exchange rate and the interest differentials of two countries. Like that of CIP, the underlying mechanism of UIP is interest arbitrage activities. For example, if domestic interest rate is lower than the expected rate of return on an identical foreign asset, investors will borrow from the home country and invest in the foreign country. The borrowing and investing process will cause domestic interest rate to increase and foreign interest rate to decrease-until two kinds of return reach the same level. What is the difference between CIP and UIP? CIP is based on the assumption that the forward market is used to cover against exchange risk. Foreign exchange transactions are conducted simultaneously in the current market and forward markets. The variables in CIP equation are all realized values. Whereas in UIP, there is not any covers against exchange risk. Transactions are conducted only in the current market. The change in spot exchange rate is estimated on its expected value. Why is it important to study UIP's potential validity/failure? First, UIP links the exchange rates and interest rates of different countries. It is a basic assumption in many economic models. The validity of these models thus partially relies on UIP's validity. Second, UIP states the equality of returns to investment in different countries. This equality means an exclusion of arbitrage opportunities. Therefore, the failure of UIP may indicate arbitrage benefits in international financial markets, which means much to international investors. Third, according to Flood and Rose (2001), "deviations from UIP are the basis for interest rate defense of fixed exchange rate." Since interest rate defense of fixed exchange rates is similar to the use of interest rate policy to stabilize an exchange rate, failure of UIP also ensures the effectiveness of interest rate policy to stabilize an exchange rate. What are the results of empirical UIP studies? Empirically, under the assumption of rational expectation, UIP is always tested in a form of equality between realized change in spot exchange rate and interest rate differential. Its empirical failure is well known. Concerning UIP's empirical failure, studies of UIP can be classified into two categories: The first is to explain UIP's empirical failure by considering violations to its basic assumptions. These violations include the irrational expectation indicated by Frankel and Froot (1990) and a time-varying risk premium studied by Fama (1984) and Malliaropulos (1997). In sum, these studies give mixed evidence for the validity of UIP. Another branch of UIP studies is based on the intuition that UIP is actually a long-run relationship obscured by short-run exogenous shocks. Economists have used methods that can extract long-run information to study this feature. Their tools include cointegration analysis (e.g. Moosa and Bhatti, 1995), using long-run average data (e.g. Lothian, 1998). Most of these studies yield results favoring a long-run UIP relationship. Definitions and Related Concepts The forward premium puzzle is closely related to the failure of uncovered interest parity to hold, and the phenomenon of forward rate bias. The puzzle is the finding that the forward premium usually points in the wrong direction for the ex post movement in the spot exchange rate. Uncovered interest parity states that, if covered interest parity holds, then the forward discount and hence the interest differential, should be an unbiased predictor of the ex post change in the spot rate, assuming rational expectations. The forward rate bias puzzle is given by the fact that the forward rate does not provide an unbiased forecast of the future spot rate. To fix concepts and terms, define the forward rate at time t for a trade to occur at time k as k Ft and the spot rate at time t as St . Further, let the subjective expectation of the spot rate at time t+k, based upon time t information, be defined as ( ) t St+k ε . Assume for the moment rational expectations, viz., ) ( Et St+k . Then one should expect: t k k St+k = Ft + u + (1) Where the error term is an expectational error. In reality, regression estimates do not find a regression coefficient of unity, although the point estimate is often not statistically significantly far from the posited value. A more problematic aspect of such regressions is that the estimated regression error term often exhibits serial correlation, violating the rational expectations hypothesis. Covered interest rate parity maintains that a domestic money market investment and a foreign money market investment have the same domestic currency return as long as the foreign ex- change risk in the foreign money market investment is “covered” using a forward contract. Uncovered interest rate parity maintains that the “uncovered” foreign money market investment, which has an uncertain return because of the uncertainty about the future value of the exchange rate, has the same expected return as the domestic money market investment. The unbiasedness hypothesis states that there is no systematic difference between the forward rate and the expected future spot rate and that, consequently, the expected forward mar- ket return is zero. In this section, we develop both of these hypotheses in more detail.