# Uncovered Interest Rate Parity - UIP

## What is the 'Uncovered Interest Rate Parity - UIP'

The uncovered interest rate parity (UIP) is a parity condition stating that the difference in interest rates between two countries is equal to the expected change in exchange rates between the countries' currencies. If this parity does not exist, there is an opportunity to make a risk-free profit using arbitrage techniques.

Next Up

## BREAKING DOWN 'Uncovered Interest Rate Parity - UIP'

Assuming foreign exchange equilibrium, interest rate parity implies that the expected return of a domestic asset will equal the expected return of a foreign asset once adjusted for exchange rates. There are two types of interest rate parity: covered interest rate parity and uncovered interest rate parity. When this no-arbitrage condition exists without the use of forward contracts, which are used to hedge foreign currency risk, it is called uncovered interest rate parity.

## Uncovered Interest Rate Parity Formula and Example

The formula for uncovered interest rate parity takes into account the following variables:

E(t + k) / S(t) = the expected rate of change in the exchange rate, which is simply the projected exchange rate at time (t + k) divided by the spot rate at time t

k = the number of time periods into the future from time t

i(c) = the foreign interest rate

i(d) = the domestic interest rate.

Using these variables, the formula is:

(1 + i(d)) = E(t + k) / S(t) x (1 + i(c))

For example, assume the following situation. The current USD/euro spot rate is 1.15 and the expected exchange rate one year into the future is 1.175 USD/euro. Currently, the one-year interest rate in the euro zone is 3%. Given this information, an analyst can calculate what the expected one-year interest rate in the United States would be using uncovered interest rate parity. The calculation would be:

(1 + i(c)) = 1.175 / 1.15 x (1 + 3%)

When solving for i(c), it is calculated to be 5.24%

There is only limited evidence to support uncovered interest rate parity, but economists, academics and analysts still use the theory as a theoretical device to represent rational expectation models. This is because of the assumption that capital markets are efficient. If capital markets are efficient, the price of a currency forward contract at any time in the future would equal E(t + k), making the uncovered interest rate parity equation valid. Based on market data, there is evidence to support covered interest rate parity, as shown by deviations from covered interest parity over time.

RELATED TERMS
1. ### Interest Rate Parity

A theory in which the interest rate differential between two ...
2. ### Parity

1. In general, a situation of equality. Parity can occur in many ...
3. ### Parity Product

A brand of good that has enough similarities with other brands ...
4. ### Covered Interest Rate Parity

This term refers to a condition where the relationship between ...

When dealing with foreign exchange (FX), a situation where the ...
6. ### Purchasing Power Parity - PPP

An economic theory that estimates the amount of adjustment needed ...
Related Articles

### Explaining Uncovered Interest Rate Parity

Uncovered interest rate parity is when the difference in interest rates between two nations is equal to the expected change in exchange rates.
2. Managing Wealth

### Understanding Risk Parity

Risk parity is an investment strategy that focuses on the allocation of risk across a portfolio.
3. Markets

### Macroeconomics: Currency

By Stephen Simpson For citizens of different countries to conduct trade, they have to buy and sell each other's currencies. The price of a nation's currency, expressed as an amount of a second ...
4. Markets

### The International Fisher Effect: An Introduction

The Fisher models have the ability to illustrate the expected relationship between interest rates, inflation and exchange rates.
5. Markets

### 10 Countries With Lower Interest Rates Than the US

Learn about the 10 countries with lower interest rates than the United States and how interest rates indicate a country's economic outlook.
6. Markets

### When Will Interest Rates Rise?

Find out if -- and why -- the Federal Reserve will keep raising interest rates and what that might mean for savers, investors and the entire economy.

### Main Factors That Influence Exchange Rates

The exchange rate is one of the most important determinants of a country's relative level of economic health, and can impact your returns.
8. Markets

People will do anything to get a little extra money. If you need some cash, here are some ways you can borrow without much hassle.
9. Markets

### How Interest Rates Affect The U.S. Markets

Interest rates can have both positive and negative effects on U.S. stocks, bonds and inflation.
10. Markets

### Forces Behind Interest Rates

Interest is a cost for one party, and income for another. Regardless of the perspective, interest rates are always changing.
RELATED FAQS
1. ### How do changes in national interest rates affect a currency's value and exchange ...

Understand the role that changes in interest rates can play in determining the value and foreign exchange rate of a country's ... Read Answer >>
2. ### How can an investor reduce interest rate risk?

Learn about the different ways investors can reduce interest rate risk. Locking in interest rates increases certainty for ... Read Answer >>
3. ### What is the difference between real and nominal interest rates?

Learn what nominal interest rates and real interest rates are, how real interest rate takes into account the inflation rate, ... Read Answer >>
4. ### What are the nations with the lowest PPP (purchasing power parity) with respect to ...

Learn how purchasing power parity (PPP) is used to compare the price of goods between countries, and which countries have ... Read Answer >>
5. ### How accurate is the forward rate in predicting interest rates?

Find out why forward rates are inconsistent and limited predictors of actual future interest rates, primarily because the ... Read Answer >>
6. ### What are the advantages of using an effective interest rate figure?

Understand what is meant by the effective interest rate, and learn why the effective rate calculation is preferred over the ... Read Answer >>
Hot Definitions
1. ### Sell-Off

The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
2. ### Brazil, Russia, India And China - BRIC

An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
3. ### Brexit

The Brexit, an abbreviation of "British exit" that mirrors the term Grexit, refers to the possibility of Britain's withdrawal ...
4. ### Underweight

1. A situation where a portfolio does not hold a sufficient amount of a particular security when compared to the security's ...
5. ### Russell 3000 Index

A market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of ...
6. ### Enterprise Value (EV)

A measure of a company's value, often used as an alternative to straightforward market capitalization. Enterprise value is ...