rate that exists at that date in the future, in which case she has an uncovered international
investment, and she is exposed to exchange rate risk.
An investor can compare the return on a covered international investment to the return on a home
investment using the covered interest differential (CD). The exact expression is CD = (1 + if)f/e
− (1 + i), where the i’s are the foreign (subscript f) and domestic interest rates, e is the spot
exchange rate, and f is the forward exchange rate. A useful approximation is CD = F + (if− i),
where F is the forward premium (discount if negative) on the foreign currency. If CD is not zero
(or within a small range close to zero, determined by transactions costs), then international
investors can engage in covered interest arbitrage—buying a country’s currency spot and selling
it forward, while making a net profit from the combination of the interest rate difference and the
forward premium or discount. Because covered interest arbitrage is essentially riskless (as long
as there is no threat of exchange controls or similar government impediments), this arbitrage
should drive the covered differential to be essentially zero—covered interest parity. Covered
interest parity links four current market rates together—the forward exchange rate, the spot
exchange rate, and the interest rates in the two countries. If one of these rates changes, then at
least one other also must change to reestablish covered interest parity.
At the time that an investor makes the investment, he can calculate the return expected on an
uncovered international investment using the spot exchange rate that he expects to exist in the
future. He can compare this expected return to the return on a home investment using the
expected uncovered interest differential (EUD). The exact expression is EUD = (1 + if)eex/e − (1
+ i), where eex is the expected future spot exchange rate. A useful approximation is that EUD
equals the expected rate of appreciation (depreciation if negative) of the foreign currency plus
the interest differential (if− i). The box on “The World’s Greatest Investor” provides a profile of
George Soros, who has made (and sometimes lost) billions of dollars with large uncovered or
speculative international investment positions.
An uncovered international investment is exposed to exchange rate risk. Nonetheless, the
investor may still undertake the uncovered investment, because the expected return is high
enough to compensate for the risk, or, more subtly, because the uncovered investment may
actually reduce the risk of the investor’s overall portfolio because of the benefits of
diversification of investments. If risk considerations are small, then investors will shift toward
investments with higher (expected) returns. Demand-supply pressures on market rates will drive
rates to eliminate the return differential, so that the uncovered interest differential is essentially
zero—uncovered interest parity.
The final section of the chapter presents some evidence on whether the various parity conditions
actually hold. In normal times covered interest parity holds well between currencies of countries
whose governments permit free movements of international capital. The box “Covered Interest
Parity Breaks Down,” a combined global financial and economic crisis and euro crisis box,
documents and discusses deviations from covered interest parity that developed during the crises.
It is more difficult to test uncovered interest parity, because we cannot observe the expected
future spot exchange rate in the market. (If we use the forward rate as an indicator of the
expected future spot exchange rate, then we are really just testing covered interest parity.)