Question

What does Interest parity between two countries mean?  

How does it appreciate or depreciates a currency?

Also, what is the difference between Uncovered and Covered Interest parity?

Answer 1

Interest rate parity between 2 countrie means that investors are indifferent towards the deposit interest rates that are available in two different countries. This is an equilibrium state which allows no arbitrage. In this state the difference between the interest rate of 2 countries is equal to difference between forward exchange rate and spot exchange rate.

This relation is given by

where

It appreciates or depreciates the currencies based on the following mechanism-

Lets say one country offers a higher risk-free rate of return in one currency than other. This is an arbitrage opportunity since one can borrow locally, buy the currency of higher return currency and invest there and earn for free. But, the country that offers the higher risk-free rate of return will be exchanged at a more expensive future price than the current spot price. This will result in appreciation of this currency. This will remove the arbitrage opportunity in currency markets. Investors cannot lock in the current exchange rate in one currency for a lower price and then purchase another currency from a country offering a higher interest rate.

Difference between covered and uncovered interest parity-

In Covered interest parity one uses forward or futures contracts to cover exchange rates, which can then be hedged in the market.

In uncovered interest rate parity one forecasts rates and and does not cover exposure to foreign exchange risk – which means there are no forward rate contracts, and only expected spot rates are used.