Interest rate parity is defined as the interest rate and exchange rate of two countries are equal. Arbitrage opportunity will be occurred if there is unequal interest rate between the countries. Investors will borrow at the country that offer lower interest rate, exchange it at spot rate through forward contract and invest in the country that offer higher interest rate. CIP and UIP are the two forms of interest parity (Moneyterms.co.uk, 2010).
Covered interest parity is defined as interest rate for the domestic and foreign countries are equal to the values of the spot and forward exchange rate. When interest rates between the countries are equilibrium, there are no arbitrage opportunities can be made (Investopedia, 2010).
id and ic are represent as the interest rate in domestic country and foreign country. While the F and S are represent as the forward and spot exchange rate.
Three assumptions must be made in order to hold the interest parity. Firstly there is perfect capital mobility, which allows for arbitrage to take place. Secondly, there are no transaction costs. Transaction costs do not exist or are only an insignificant charge. Thirdly is that there is no default risk. Financial instruments are protected against default of lenders and government (GRIPS, 2010).
If the interest rate in home country is less than the interest rate in overseas country, the value of money invest in home country will be smaller than the value of money converted and invest in overseas country.
(1 + id) < (F/S)(i + ic)
The imbalance of interest rate would create an arbitrage opportunity where investors would borrow at the home country which offer lower interest rate, convert it to the overseas currency and invest in overseas country which offer higher interest rate(Worldlingo, 2009).
Uncovered Interest Parity
Uncovered interest parity is defined as the discrepancy of the interest rate between countries is identical to the expected rates between the countries�� currencies. There is an opportunity to make a profit if the interest parity does not exist. Unfortunately compare to CIP, UIP do not cover for exchange rate risk. CIP has the forward contract which use to avoid exchange rate risk, however UIP don��t has the forward contract which help to avoid risk. Investors have to predict the future spot rate where it actually creates a risk.
Below is the formula that identifies Uncovered Interest Parity:
t and (t+1) are is equivalent as the current and following period. While are equivalent as the home and overseas interest rate. Moreover are representing as the spot exchange rate and future spot exchange rate. (Alam, 2007).
For instance, interest rate in home country (US) is equal to the interest rate in overseas country (UK). Investing in the US or UK would give the same return regardless of the exchange rate risk. If the dollar depreciates against the sterling, invest in UK would earn more profit than invest in US. In order to induce investors to invest in US, US has to increase their interest rate by the amount of the currency depreciate as compared to the UK.
The difference between both of them is that covered interest parity uses the exchange rate on the forward market to replace the expected exchange rate on the spot market. Forward market is used in order to protect the exchange rate risk. Foreign exchange transactions are conducted simultaneously in the current and forward market. However for uncovered interest parity, transaction is conducted in spot market and does not use the forward market to cover it exchange rate risk. The expected spot exchange rate is used instead of the forward exchange rate (Alam, 2007).
The Role of Risk Aversion
Covered interest parity
A risk aversion is defined as a person do not like risk; they will not choose any high risk stocks into their portfolio but rather looking for more ��safer�� investment that generate low return (Investopedia, 2010).
As we know covered interest parity can eliminate the exchange rate risk by using the forward contract. Besides the exchange rate risk, according to Aliber (1973) it argued that assets also involved sovereign or political risk. Example of political risk which occurred from foreign government unable to keep its promise to repay the loan or interest and moreover foreign government would introduce different form of exchange control to prevent the investors from retrieving his or her funds (Paul and MacDonald, 2000).
However this kind of risk can be avoided if the investors use domestic and foreign financial instruments such as US dollar bonds, which are issued in the same financial centre within the same political jurisdiction. Invest in domestic or foreign bonds within the same government judgement will definitely help investors to avoid the political risk (Paul and MacDonald, 200).
To test the interest parity for covered interest parity, below is the following regression:
Under the null hypothesis, it is tested as �� =1. If the result show ��=1, means the CIP is hold. However if the result �¡ï¿½1 means there is differences in interest rate between the two countries (Alam, 2007).
Uncovered Interest parity
The following equation is used to test the different in interest rate resulting changes in the exchange rate between the domestic and foreign countries:
is representing as the percentage of the currency appreciation over k periods and equal the different between foreign interest rate and domestic interest rate in k-period.
Under the null hypotheses of UIP, it shows that ��=1. For instance when the foreign interest rate is higher than the domestic interest rate, the currency will tend to appreciate in line. However according to Froot and Thaler (1990) research, they found that coefficient �� is less than one and in fact �� is estimated to be less than zero. The average coefficient is estimated to be -0.88. For examples, since year 1996, interest rate in UK is higher than in Germany but the sterling is always depreciated against the DM. This relationship show that �� were negative rather than being positive one (Sushil, 1999).
The following expression is the test of uncovered interest parity within a monetary-portfolio framework (Frankel,1983):
The is represent as the constant proportional to the relative risk aversion coefficient; however is representing as the investor��s holdings of foreign and domestic assets under the logarithmic form (Guillaume, 2007).
Moreover risk premium affect the result of the volatility of exchange rate. Underlying currencies will become more risky if there is an unstable on the variations of exchange rates.
According to Lewis (1995), research showed that risk premium is depends on the risk aversion. The decision of holding domestic and foreign assets will be affected by the risk premium. Risk premium is important for invertors that are risk averse. The reason is since investing in foreign is much more risky, they will like to have more return to compensate its losses.
The task of risk aversion investoris to decide the percentage of holdings the domestic and foreign financial assets. For instance, a risk aversion agent will choose to diversify its investment into two different fraction of investment. First the safe domestic assets which referred as covered interest parity and second the foreign bonds which referred as uncovered interest parity. This diversification will tend to reduce the marginal utility of wealth in the investors (Guillaume, 2007).
The different between UIP and CIP is that UIP included exchange rate risks which cannot be eliminate by forward contract. As a result, the risk adverse investors will tend to demand a premium for holding the risky assets.
Conclusion
The different between CIP and UIP is that CIP do not involved exchange rate risk while UIP do. The risk lover investors can choose to take uncovered interest parity where it would poses high return and also high risk. However for the risk adverse investors, they should go for covered interest parity, where it actually eliminated exchange rate risk and thus low return. There are financial tools in the market which help to reduce risk for investors. For instance mutual funds, hedging fund, government bonds, and fixed deposits. Last but not least, diversification is the best solution to help investors to avoid risk.
