1. What is Uncovered Interest Rate Parity?

Uncovered Interest Rate Parity (UIP) is an economic theory that states the difference in interest rates between two countries should equal the expected change in exchange rates between their currencies. It suggests that higher interest rates in one country will be offset by that country's currency depreciation.

2. How Does the Calculator Work?

The calculator uses the Uncovered Interest Rate Parity formula:

Where:

• \( ES_{t+1} \) — Expected Future Spot Rate
• \( e_0 \) — Current Spot Exchange Rate
• \( r_d \) — Domestic Interest Rate
• \( r_f \) — Foreign Interest Rate

Explanation: The formula calculates the expected future exchange rate based on current spot rate and the interest rate differential between two countries.

3. Importance of Uncovered Interest Rate Parity

Details: UIP is crucial for international investors, currency traders, and policymakers as it helps predict future currency movements and assess foreign exchange risk. It forms the basis for many international investment decisions and hedging strategies.

4. Using the Calculator

Tips: Enter current spot exchange rate, domestic interest rate, and foreign interest rate as percentages. All values must be positive numbers.

5. Frequently Asked Questions (FAQ)

Q1: What's the difference between covered and uncovered interest rate parity?
A: Covered IRP uses forward exchange rates while uncovered IRP uses expected future spot rates. Covered IRP involves no risk, while uncovered IRP carries exchange rate risk.

Q2: Does uncovered interest rate parity hold in real markets?
A: Empirical evidence shows UIP often fails to hold in short-term due to risk premiums, market inefficiencies, and investor behavior, though it tends to hold better over longer periods.

Q3: How do central bank policies affect UIP?
A: Central bank interest rate decisions directly impact interest rate differentials, which according to UIP should lead to corresponding exchange rate adjustments.

Q4: What are the limitations of UIP theory?
A: UIP assumes perfect capital mobility, rational expectations, and risk-neutral investors, which may not always reflect real market conditions.

Q5: How is UIP used in currency forecasting?
A: Traders and analysts use UIP as a baseline model for currency predictions, though they often adjust for risk premiums and market sentiment factors.