Uncovered Interest Parity
UNCOVERED INTEREST PARITY Let us take a simple example in order to understand uncovered interest parity condition. The interest rate in the Eurozone for one year is slightly above 4% when compared to Czech interest rate which is less than 3% for one year. But despite still having negative interest rate differential we can see many investors still preferring and holding Czech assets. This is because financial market participants expects the Czech crown shall appreciate in the future and are ready to compensate for the negative interest rate differential.
Now let us see why uncovered interest parity does not hold in long run: Because of the presence of such an uncertainty, uncovered interest rate may not hold. Furthermore even the empirical evidence emphasizes that it does not hold generally. In general when compared to covered interest parity, uncovered interest parity is more difficult to test due to the presence of expected exchange rate changes which are unobservable.
One of the reasons for uncovered interest parity may not hold is that of the inefficiency of the capital markets due to which it provides chance for money managers, speculators and other hedge funds to exploit this inefficiency for making profit. A new area of research involves investigation of whether uncovered interest parity holds for emerging markets. Bansal and Dahlquist (2000) found that there was a basic asymmetry in which UIP holds. In particular, they find that when the U. S. interest rate is lower than foreign country rates, uncovered interest parity (UIP) holds, while UIP fails to hold when the U.
S. rate is higher. The other important factor which determines the measure of failure of UIP not holding is the Gross Domestic Product per capita of the foreign country. . For example Uncovered interest parity does not hold for G-7 countries. But it was argued that this is because under the uncovered interest parity model a country’s nominal interest rate is determined by the world interest rate plus the expected change in exchange rates, where the formulation of such expectations is based on neoclassical assumptions.
With this one can clearly say that central Banks have the power to act autonomously in their respective countries and will act according to the economic changes. Assuming for a moment no other sources of deviation from UIRP, when agents are confident of forecasts then capital will move and UIRP will tend to hold; when they are not, however, then one can have a situation in which nvestors in aggregate believe the return that can be earned in one nation exceeds that in the other, but they lack the conviction to act. Due to which capital flow will be in sufficient volume and UIRP will not hold. One of the main drawbacks of the UIP condition is that it does not say, as is sometimes thought, that a one percentage point increase in the sterling rate will cause a one percent depreciation of the exchange rate.
In fact, in response to the higher return on sterling assets there would be a capital inflow and sterling would appreciate, not depreciate. Furthermore this would happen instantly. The explanation for this can also be found in the UIP condition. However on the other hand uncovered interest parity and covered interest parity will only hold good when the government or authorities do not lay any obstacle to the circulation of your money or to the financial capital.
Many of the governments in the earlier period used to lay down a number of restrictions regarding the movement of the capital in respect to how much cash could be stimulated out of the country or brought to a country. But when u compare it to now, it’s been changed drastically especially to the developed countries like US, UK, Germany but on the other hand it’s still the same with the developing countries like India, Sri Lanka, China where there are restrictions on the movement of the capital.
Also there is always a danger of government slapping on the restrictions on your savings in the country. In such a circumstance it is very unlikely to find the parity conditions holding. At the end I would like to conclude it by saying that if both covered and uncovered parity holds good then the forward rate must be equal to the market’s expectation of the future spot rate. Reference Copeland,L. (2005). Exchange Rates and Interenational Finance. Pearson Education Limited,Essex.
