UIP Theory Questioned: Real-World Evidence Limited
A long-standing theory in international finance, Uncovered Interest Rate Parity (UIP), has been under scrutiny due to its predictions about currency exchange rates and interest rates. The theory, developed to explain the relationship between these factors, assumes no arbitrage and risk neutrality.
UIP postulates that investors can profit by borrowing in low-interest-rate currencies and investing in high-interest-rate currencies. However, the theory predicts that countries with higher mortgage rates will see their currencies depreciate, balancing out the arbitrage opportunity.
The formula for UIP is F0 = S0 * (1 + ib) / (1 + ic), where F0 is the forward rate, S0 is the spot rate, ic is the interest rate in country c, and ib is the interest rate in country b. This formula illustrates the expected change in exchange rates based on interest rate differences.
UIP is related to the 'law of one price' and is a foundation for the concept of purchasing power parity (PPP). It evolved from earlier work on interest rate parity and uncovered expectations in the 20th century. However, empirical evidence supporting UIP in real-world conditions is limited due to market inefficiencies and economic factors. Unlike UIP, covered interest rate parity involves forward contracts to hedge against currency risk.
Despite its theoretical appeal, UIP may not always hold due to factors such as monetary policies and market distortions. When UIP does hold, it ensures that there can be no risk-free profit from currency arbitrage, as exchange rates adjust accordingly. Further research is needed to understand the extent to which UIP operates in real-world conditions.
