Interest Rate Parity
Covered and uncovered parity: how interest differentials pin down forward exchange rates.
The Interest Rate Parity model, in writing
Definition
No-arbitrage across currencies: interest differentials must equal expected (uncovered) or forward-locked (covered) currency depreciation.
CIP: F/S = (1+i)/(1+i*); UIP: i − i* ≈ expected depreciation
The intuition
If yen deposits pay 1% and dollar deposits 5%, the dollar must be expected to fall ~4%, otherwise money floods one way until prices move. CIP holds almost exactly (it's enforced by arbitrage); UIP fails often enough to fund the carry trade.
Exam tip
Keep covered vs uncovered straight: CIP uses the forward rate (riskless), UIP uses expectations (risky).
Related models in Trade & Open Economy