Uncovered Interest Rate Parity

Question 1

Define UIP condition

Answer 1

The difference in interest rates between the two countries will equal the relative change in exchange rates over the same period.

Question 2

Describe UIP scenario

Answer 2

Initially, UK has an interest rate on bonds of 1%. BOE announces an immediate 2.5% rise, lasting for a year, and then the rate will return to 1%.

UK bonds are now relatively more attractive than US bonds.

In the Forex market, traders sell $ and buy £. This causes the pound to appreciate by 2.5% in line with the UIP condition, and e falls. This occurs almost instantaneously, with arbitrage eliminating any profit opportunity.

Over the course of the year, the pound will depreciate by 2.5% to the original exchange rate.

Question 3

Formal UIP Condition.

Answer 3

Interest gain from holding home rather than foreign bonds = loss from expected home currency depreciation.

log approximation: it - i* = log et+1- loget

Question 4

What causes UIP curve to shift?

Answer 4

Change in foreign interest rate. If the world interest rate fell, then the UIP curve would shift inwards.

Question 5

What causes movement along the UIP curve?

Answer 5

Change in home rate (as this is on the y axis).