essay question: Discuss the difference between covered and uncovered interest parity and explain both concepts

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Expert Solution

A covered interest parity is an arbitrage relation. Arbitrage instruments are bought and sold in different markets to turn a profit from the difference in rates between the two different markets.

A covered interest parity means there is not enough difference between the rates in the different markets to make a profit. The forward rate that the trader would secure is only enough to off-set the actual interest rate on the currency instead of profiting.

It's considered an arbitrage relation because the trader has all of the information available to them at the moment; spot interest rates and the forward lock-in rates for however long.

An uncovered interest parity is attempting to forecast future spot rates through the relationship between the currency interest rates and the current spot rate. The trader cannot lock in any kind of future rate, only make a projection based on their own analysis.

The greatest difference in these type of instruments is that the covered interest parity will have a locked in futures rate. An uncovered interest parity is more of a speculation in that the trader has to attempt to project where the future rate will end up.

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