INTERNATIONAL FINANCE

TEAM MEMBERS
KEERTHANA.B
KIRAN RAJ
MAHESH R
MAKLAL
MANJOTHA
MANUKIRAN S
MOHANAPRASATH C
MOWSHMI N
MUKESH N
MUTHU KUMAR
 Interest Rate Parity (IRP)
Interest rate parity (IRP) is a theory according to
which the interest rate differential between
two countries is equal to the differential
between the forward exchange rate and the
spot exchange rate.
 FORMULA

F0​=Forward Rate
S0​=Spot Rate
ic​=Interest rate in country c ib​
=Interest rate in country b​
 Covered Interest Rate Parity
Covered interest rate parity refers to a
theoretical condition in which the relationship
between interest rates and the spot and
forward currency values of two countries are
in equilibrium. The covered interest rate parity
situation means there is no opportunity for
arbitrage using forward contracts, which often
exists between countries with different
interest rates.
 FORMULA

id​=The interest rate in the domestic currency or the base currency
if​=The interest rate in the foreign currency or the quoted currency
S=The current spot exchange rate
F=The forward foreign exchange rate​
Limitations of Using Covered Interest Rate Parity

• Interest rate parity says there is no opportunity for

interest rate arbitrage for investors of two different
countries. But this requires perfect substitutability and
the free flow of capital. Sometimes there are arbitrage
opportunities. This comes when the borrowing and
lending rates are different, allowing investors to capture
riskless yield.
• For example, the covered interest rate parity fell apart
during the financial crisis. However, the effort involved to
capture this yield usually makes it non-advantageous to
pursue
What Is Uncovered Interest Rate Parity (UIP)?

• Uncovered interest rate parity (UIP) theory

states that the difference in interest rates
between two countries will equal the
relative change in currency foreign
exchange rates over the same period. It is
one form of interest rate parity (IRP) used
alongside covered interest rate parity.
 FORMULA

• F0​=Forward rate S0​=Spot rate ic​

=Interest rate in country c
ib​=Interest rate in country b​
Limitations of Uncovered Interest Parity
• There is only limited evidence to support UIP, but
economists, academics, and analysts still use it as a
theoretical and conceptual framework to represent
rational expectation models. UIP requires the
assumption that capital markets are efficient.
• Empirical evidence has shown that over the short-
and medium-term time periods, the level of
depreciation of the higher-yielding currency is less
than the implications of uncovered interest rate
parity. Many times, the higher-yielding currency has
strengthened instead of weakened.
 The Difference Between Covered
Interest Rate Parity and Uncovered
Interest Rate Parity
Covered interest parity involves using forward
contracts to cover the exchange rate. Meanwhile,
uncovered interest rate parity involves forecasting
rates and not covering exposure to foreign exchange
risk—that is, there are no forward rate contracts,
and it uses only the expected spot rate. There is no
difference between covered and uncovered interest
rate parity when the forward and expected spot
rates are the same.