Uncovered Interest Parity

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UNCOVERED INTEREST PARITY
Let us take a simple example in order to understand uncovered interest parity condition. The interest rate in the Eurozone for one year is slightly above 4% when compared to Czech interest rate which is less than 3% for one year. But despite still having negative interest rate differential we can see many investors still preferring and holding Czech assets. This is because financial market participants expects the Czech crown shall appreciate in the future and are ready to compensate for the negative interest rate differential. Now let us see why uncovered interest parity does not hold in long run: Because of the presence of such an uncertainty, uncovered interest rate may not hold. Furthermore even the empirical evidence emphasizes that it does not hold generally. In general when compared to covered interest parity, uncovered interest parity is more difficult to test due to the presence of expected exchange rate changes which are unobservable. One of the reasons for uncovered interest parity may not hold is that of the inefficiency of the capital markets due to which it provides chance for money managers, speculators and other hedge funds to exploit this inefficiency for making profit. A new area of research involves investigation of whether uncovered interest parity holds for emerging markets. Bansal and Dahlquist (2000) found that there was a basic asymmetry in which UIP holds. In particular, they find that when the U.S. interest rate is lower than foreign country rates, uncovered interest parity (UIP) holds, while UIP fails to hold when the U.S. rate is higher. The other important factor which determines the measure of failure of UIP not holding is the Gross Domestic Product per capita of the foreign country. . For example Uncovered interest parity does not hold for G-7 countries. But it was argued that this is because under the uncovered interest parity model a country's nominal interest rate is determined by the world...
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