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•
Uncovered Interest Parity (UIP)
–
No arbitrage condition for
expected returns
–
States that the expected returns must be equal when expressed in a
common currency
–
We assume risk neutrality; e.g. that a risk neutral US investor does not
care that the left hand side is certain, while the right hand side is risky.
•
Uncovered Interest Parity (UIP)
–
Knowing the expected exchange rate and the interest rates for each
currency, we can solve for the spot exchange rate:
•
Interest parity conditions
–
CIP:
–
UIP:
–
Thus CIP plus UIP imply:
•
Intuition: If investors do not care about risk, then they have no reason to prefer to
avoid risk by using the forward rate rather than waiting for the expected future
spot rate to materialize.
•
An important testable implication:
–
Lefthand side is the
forward premium
of Euros (+) or
forward discount
of Euros (–)
–
Says how much more/less investors are willing to pay for the forward
versus the spot rate.
–
Righthand side is
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 Spring '10
 BALLIE

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