Forward Exchange and

International Financial Investment

Group 1
Arnaud Cavallin 63335
KunLong Jiang 62878
Simone Fabbri 63292 08.10.2024
Table of Contents
1) Exchange-Rate Risk

2) The Market Basics of Forward Foreign Exchange

a) Hedging using Forward Foreign Exchange
b) Speculating using Forward Foreign Exchange
c) Other FX contracts: Futures, Options and Swaps

3) International Financial Investment

4) International Investment with Cover

a) General Idea
b) Covered Interest Arbitrage
c) Covered Interest Parity

5) International Investment without Cover

a) General Idea
b) Uncovered Interest Parity

6) Does Interest Parity Really Hold? Empirical Evidence

a) Evidence on Covered Interest Parity
b) Evidence on Uncovered Interest Parity
c) Evidence on Forward Exchange Rates and Expected Future Spot Exchange Rates
Exchange-Rate Risk
Definition: “Exchange Rate Risk is the potential financial loss due to fluctuations in the exchange rate between currencies”

This Risk may affect: Manage Exchange Rate Risk:

• Assets: when a company holds assets in a foreign currency, a ➢ Hedging: using financial instruments to reduce or eliminate the
depreciation of that currency can reduce the domestic value of risk of adverse price movements in an asset or liability. In the
those assets. For example, foreign receivables lose value if the context of exchange rate risk, it means securing a fixed exchange
foreign currency weakens against the domestic currency; rate for future transactions to protect against fluctuations;

• Liabilities: when a company has liabilities in a foreign currency, an ➢ Speculating: taking on exchange rate risk with the expectation of
appreciation of that currency can increase the cost of settling those making a profit from future price movements. It entails betting on
liabilities. For instance, a company with a loan in a foreign currency the direction of exchange rate changes without the intention of
must pay more in domestic currency if the foreign currency using the currency for a transaction.
strengthens against the domestic currency.
Hedging using Forward foreign exchange contracts
Definition: “A Forward foreign exchange contract is a customized agreement between two parties to exchange a specified
amount of one currency for another at a predetermined exchange rate on a specified future date. This contract allows
businesses and investors to lock in exchange rates, reducing uncertainty related to future currency fluctuations.”
Hedging an Asset denominated in a foreign currency Hedging a Liability denominated in a foreign currency

➢ Sell Forward: when an entity expects to receive foreign currency in ➢ Buy Forward: when an entity has a future payment obligation in
the future (an asset), it can hedge this exposure by entering into a foreign currency (a liability), it can hedge this risk by entering into
forward contract to sell that currency at the current forward rate. a forward contract to buy that currency at the current forward
This secures the future value in domestic currency. rate. This ensures that the future cost in domestic currency is fixed.

Example: A US company anticipates receiving €1 million from a EU Example: A US company needs to pay a supplier €1 million in one
client in one month. To hedge this expected asset, it enters into a month. To hedge this liability, it enters into a forward contract to buy
forward contract to sell €1 million at a forward rate of 1.20 $/€. €1 million at a forward rate of 1.2 $/€. This ensures that the company
Regardless of future fluctuations in the exchange rate, the company will pay $1.2 million in six months, regardless of any future changes in
will receive $1.2 million when the payment is made in six months. the exchange rate.
Speculating using Forward foreign exchange contracts
Hypothesis: “Speculators’ pressures on supply and demand should drive the forward exchange rate to equal the
average expected value of the future spot exchange rate”.
Speculating on currency Appreciation: Speculating on currency Depreciation:

➢ Buy Forward: If a speculator believes that the value of a foreign ➢ Sell Forward: if a speculator believes that a foreign currency will
currency will increase relative to the domestic currency, they can depreciate, they can enter into a forward contract to sell that
enter into a forward contract to buy that currency at the current currency at the current forward rate (expensive). At maturity, if the
forward rate (cheap). At maturity, if the currency appreciates as currency depreciates as expected, they can buy it back at the lower
anticipated, they can sell it at the higher spot rate, earning a profit. spot rate, making a profit..

Example: A trader anticipates that the foreign currency will rise in value Example: A speculator believes that the foreign currency will fall in
from its current forward rate of 1.10 $/€. They enter into a forward value from its current forward rate of 1.30 $/€. They enter into a
contract to buy €1 million at this rate. If the actual spot rate in three forward contract to sell €1 million at this rate. If the spot rate in three
months rises to 1.20 $/€, the trader can sell €1 million for $1.2 million months drops to 1.20 $/€, the trader can buy back €1 million for only
spot, buying €1 million for 1.1$ million thanks to the forward contract, $1.2 million, resulting in a profit of $100,000 from the forward
resulting in a profit of $100,000. contract.
Questions
Question 1: “Explain the nature of the exchange-rate risk for each of the following, from the perspective of the U.S. firm
or person. In your answer, include whether each is a long or short position in foreign currency.
a) A small U.S. firm sold experimental computer components to a Japanese firm, and it will receive payment of 1 million
yen in 60 days;
b) An American college student receives a birthday gift of Japanese government bonds worth 10 million yen, and the
bonds mature in 60 days;
c) A U.S. firm must repay a yen loan, principal plus interest totalling 100 million yen, coming due in 60 days.
How would you hedge each exposure?

Question 2: “The current spot exchange rate is $0.50/SFr. The current 180-days forward exchange rate is $0.52/SFr. You
expect the spot rate to be $0.51/SFr in 180 days. How would you speculate using a forward contract?”.

Question 3: “The current spot exchange rate is $1.20/€. The current 90-day forward exchange rate is $1.18/€. You expect
the spot rate to be $1.22/€ in 90 days. How would you speculate using a forward contract? If many people speculate in
this way, what pressure is placed on the value of the current forward exchange rate?”.
Answers
Answer 1:
a) U.S. firm selling components (receiving 1 million yen in 60 days):
Position: Long position (asset) in foreign currency → Hedge: Sell yen forward to lock in the exchange rate.
b) American student with Japanese bonds (worth 10 million yen, maturing in 60 days):
Position: Long position (asset) in foreign currency → Hedge: Sell yen forward to lock in the exchange rate.
c) U.S. firm repaying a yen loan (100 million yen due in 60 days):
Position: Short position (liability) in foreign currency → Hedge: Buy yen forward to secure the exchange rate for
repayment.

Answer 2: “To speculate using a forward contract in this scenario: you expect the spot rate in 180 days to be $0.51/SFr,
but the 180-day forward rate is $0.52/SFr. Since the expected future spot rate ($0.51) is lower than the forward rate
($0.52), you should sell Swiss francs forward at the higher forward rate. If your expectation is correct and the spot rate in
180 days is indeed $0.51/SFr, you can profit by buying Swiss francs in the spot market at $0.51/SFr and fulfilling the
forward contract at $0.52/SFr, making a profit of $0.01 per Swiss franc.

Answer 3: “To speculate using a forward contract in this scenario: you expect the spot rate in 90 days to be $1.22/€, but
the 90-day forward rate is $1.18/€. Since the expected future spot rate ($1.22) is higher than the forward rate ($1.18), you
should buy euros forward at $1.18/€. If your expectation is correct, in 90 days, you can sell € at the higher spot rate of
$1.22, making a profit of $0.04 per €.
If many people speculate this way, the increased demand for buying euros forward will put upward pressure on the
current forward exchange rate.
Other FX contracts: Futures
Definition: “Futures contracts are standardized agreements traded on exchanges to buy or sell a specific amount of a
foreign currency at a predetermined price on a future date. Unlike forward contracts, futures are regulated and have set
specifications, including contract size and expiration dates.”

+Advantages:
• Liquidity: in 2024, average daily FX futures volume at CME Group exceeds $80 billion;
• Standard (simple): for British Pound (GBP/USD) futures contracts traded on the CME, the contract size is 62.500 British pounds and the
maturities available are monthly contracts for three consecutive months as well as quarterly contracts extending up to 20 quarters into the future
(March, June, September, December);
• Daily Marking to Market (Clearing House): reduced (eliminated) counterparty risk (Margin Calls – Forced Liquidation).

-Disadvantages:
• Margin Requirements: (Initial + Variation Margin): funds tied up for margin requirements cannot be used for other investments;
• Less Flexibility.
Other FX contracts: Options
Definition: “Options contracts provide the buyer the right, but not the obligation, to buy (call option) or sell (put option)
a foreign currency at a predetermined price (strike price) before (US) or on (EU) a specified expiration date.”

+Advantages:
• Limited Loss: possible loss from a long option position is only the premium paid;
• Flexibility: from one week to several months maturities. Strikes available with 0.25 cents increment (ex: cable fx).
-Disadvantages:
• Complexity: sensible to several factors (volatility), difficult to manage as a portfolio (allocations);
• Premium Costs: premium is paid upfront and can be expensive in a highly volatile environment.
Other FX contracts: Swaps
Definition: “Currency swaps are agreements between two parties to exchange cash flows in different currencies over a
specified period. This typically involves exchanging principal amounts at the start and re-exchanging them at the end of
the agreement, along with periodic interest payments.”.

+Advantages:
• Reduced Transactions Costs: only one transaction to buy the contract (portfolio of forwards);
• Improved Risk Management: periodic cashflows without the need to roll over the contract;
-Disadvantages:
• Complex Structure: portfolio of forwards;
• Counterparty Risk: OTC contract. When spot diverges from expectations, the exposure gets bigger.

1+𝑖 #𝑑𝑎𝑦𝑠
Forward Rate = 𝑆𝑝𝑜𝑡 𝑟𝑎𝑡𝑒 ⋅ 1+𝑖 𝐴 ⋅
𝐵 360
Questions
Question 1: “A U.S. company with receivables in euro expects the euro to depreciate against the dollar in the next six
months. How can it hedge this risk using FX futures”

Question 2: “A U.S. company has profits in euros but wants to protect against a euro decline, allowing gains if the euro
appreciates. What should it do?”

Question 3: “If a U.S. company can issue euro-denominated bonds at a low interest rate but needs dollars, how can it
hedge currency risk and manage its cash flows?”
Answers
Answer 1: “The company can short euro futures contracts. If the euro depreciates, the value of the futures contract will
rise, offsetting the losses from converting euros into dollars at a lower exchange rate.”

Answer 2: “The company can purchase a put option on the euro. This caps losses if the euro depreciates but allows it to
benefit if the euro strengthens.”

Answer 3: “The company can issue euro-denominated bonds and enter into a currency swap. It would swap the euros for
dollars and pay dollar interest in the swap. The euro interest from the bonds is offset by the euro interest received in the
swap, effectively converting the debt into dollar-denominated cash flows while lowering its overall financing cost.”
International Financial Investment
Definition:

This involves the allocation of capital into foreign markets, typically in the form of purchasing financial instruments like
stocks, bonds, or other assets.

Current situation:

International financial investment has grown rapidly in recent decades and are increasingly being taken into account by
portfolio managers. Their decisions about international investments are based on the returns and risks of the available
investment alternatives.

Examples:

• Buying shares of foreign companies listed on international stock exchanges.

• Investing in sovereign or corporate bonds issued by foreign governments or corporations.
• Mutual funds or exchange-traded funds (ETFs) that focus on foreign markets.
International Financial Investment
Opportunities:

• Diversification: One of the major benefits of international investments is risk diversification. By investing in different
countries, investors can spread their risk across various economic environments. If the domestic economy is
underperforming, investments in foreign markets may perform well, thereby balancing the portfolio.

• Access to Growth: Some international markets, especially in emerging economies, offer higher growth potential than
more mature domestic markets. This presents opportunities for higher returns.

Risks:

• Exchange-rate risk: This is a primary concern for international investors. Even if the value of an investment increases in
the foreign market, a depreciation of that country’s currency could reduce the actual returns when converted back into
the investor’s domestic currency.

• Regulatory and Political Risks: Different countries have different regulations and levels of political stability. Investments
in foreign countries can be more exposed to sudden changes in government policy, regulatory conditions, or political
instability.
International Investment with Cover – General Idea
Domestic investment and international investment comparison:

Ways of investing (or borrowing) = paths around a lake

iUS = Current 90-day interest rate in the

United States (not annualized)

iUK = Current 90-day interest rate in

Britain (not annualized)

e = Current spot price of the pound ($/£)

f = Current forward price of the pound, for

exchange 90 days from now ($/£)
International Investment with Cover – General Idea
How to convert present dollars into future dollars ?

→ 2 possibilities

Domestic Investment : 1 + 𝑖𝑈𝑆

International
Investment with Cover : 1 + 𝑖𝑈𝐾 ∗ 𝑓/𝑒

Covered interest differential

𝐶𝐷 = 1 + 𝑖𝑈𝐾 ∗ 𝑓/𝑒 – 1 + 𝑖𝑈𝑆

If CD > 0 → better off investing in UK

If CD < 0 → better off investing in US

Covered ? Because the investor is fully hedged against exchange-rate risk if he uses a foreign-currency investment to get
from his own currency today to the same currency in the future (green path).
International Investment with Cover – General Idea

forward premium (F) : 𝐹 = (𝑓 − 𝑒)/𝑒

→ The proportionate difference between the current forward exchange-rate value of the pound and its current spot value.

Handy approximation of CD : 𝐶𝐷 ≈ 𝐹 + 𝑖𝑈𝐾 − 𝑖𝑈𝑆

Interpretation of CD:

The net incentive to go in one particular direction around the lake depends on how the forward premium on the pound
compares with the difference between interest rates.
International Investment with Cover – Covered Interest Arbitrage

Arbitrage : The practice of taking advantage of price differences in different markets by buying an asset in one
market and simultaneously selling it in another to profit from the price discrepancy.

Covered Interest Buying a country’s currency spot and selling that country’s currency forward, to make a net profit from
Arbitrage : the combination of the difference in interest rates between countries and the forward premium on
that country’s currency.
International Investment with Cover – Covered Interest Arbitrage

Example :

A trader takes advantage of the interest rate differential between the U.S. and the U.K., as well as the absence of a
forward premium or discount on the exchange rate, to make a riskless profit. Here's how the arbitrage works step by step:

1) Buy pounds today in the spot market

2) Invest today in British Treasury Bills

until maturity

3) Cover himself against exchange-rate

risk by selling today the expected
pounds at maturity in the forward
market

4) Borrow today in US the amount in

dollars he would get at maturity

→ Instantaneous and riskless profit

If several traders take advantage of this opportunity, how will rates evolve? Will arbitrage still exist?
International Investment with Cover – Covered Interest Parity

John Maynard Keynes, himself an interest arbitrageur, argued that the opportunities to make arbitrage profits would be
self-eliminating because rates would adjust so that the covered interest differential would be driven to zero.

Condition for no arbitrage

opportunity :
CD=0 → Covered interest Parity

Interpretation:
• A currency is at a forward premium (discount) by as much as its interest rate is lower (higher) than the interest rate in the
other country (i.e., F = iUS – iUK in our example).

• The overall covered return on a foreign-currency investment equals the return on a comparable domestic-currency
investment (F + iUK = iUS).

Covered interest parity provides an explanation for differences between current spot and current forward exchange rates.

Example :
A country with an interest rate that is lower than the corresponding rate in the United States will have a forward premium
on its currency, with the percentage point difference in the interest rates equal to the percent forward premium.
International Investment without Cover - General Idea
Definition: Investing in a financial asset denominated in a foreign currency without hedging or covering the future
proceeds of the investment back into one’s own currency.

Again, how to convert present dollars into future dollars ?

→ 2 possibilities
Expected future spot rate
Domestic Investment : 1 + 𝑖𝑈𝑆 Sell £ f. spot (eex)
Buy £ f. spot (1/eex)
International
Investment without 1 + 𝑖𝑈𝐾 ∗ 𝑒 𝑒𝑥 /𝑒
Cover :

Expected uncovered interest differential

EUD = 1 + 𝑖𝑈𝐾 ∗ 𝑒 𝑒𝑥 /𝑒 – 1 + 𝑖𝑈𝑆

If EUD > 0 → better off investing in UK

If EUD < 0 → better off investing in US
Uncovered ? Because the investor is exposed to exchange-rate risk if he uses a foreign-currency investment to get from his
own currency today to the same currency in the future (green path).
International Investment without Cover - General Idea

Covered interest differential : 𝐶𝐷 = 1 + 𝑖𝑈𝐾 ∗ 𝑓/𝑒 – 1 + 𝑖𝑈𝑆

Expected uncovered interest EUD = 1 + 𝑖𝑈𝐾 ∗ 𝑒 𝑒𝑥 /𝑒 – 1 + 𝑖𝑈𝑆

differential :

Handy approximation of CD : 𝐶𝐷 ≈ 𝐹 + 𝑖𝑈𝐾 − 𝑖𝑈𝑆

Handy approximation of EUD : 𝐸𝑈𝐷 ≈ 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑎𝑝𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 + 𝑖𝑈𝐾 − 𝑖𝑈𝑆

Interpretation of EUD:

The net incentive to go in one particular direction around the lake depends on how the expected appreciation on the pound
compares with the difference between interest rates.
International Investment without Cover - Uncovered Interest Parity

Generally, the pressures on the rates will subside only when there is no further incentive for large shifts in investments.

Condition for no “expected”

arbitrage opportunity :
EUD =0 → Uncovered interest Parity

Interpretation:

• A currency is expected to appreciate (depreciate) by as much as its interest rate is lower (higher) than the interest rate in
the other country (for instance, expected appreciation of the pound = iUS – iUK).

• The expected overall uncovered return on the foreign-currency investment equals the return on the domestic-currency
investment (expected appreciation +iUK = iUS).

Uncovered interest parity provides an explanation for differences between current spot and current expected future spot.

Example :
A country with an interest rate that is lower than the corresponding rate in the United States will have an expected future
spot premium on its currency, with the percentage point difference in the interest rates equal to the percent expected
future spot premium.
Questions
Question 1: “What factors influence decisions about international financial investments?”

Question 2: “How do we calculate overall returns on foreign financial assets?

Question 3: “What are the two major ways to convert foreign-currency-denominated returns back into domestic
currency?”

Question 4: “What is the forward premium (F)?”

Question 5: “What happens when many traders engage in covered interest arbitrage?”
Answers
Answer 1: “International investment decisions are based on the returns and risks of available investment alternatives.
Specifically, these include factors like exchange rate movements, interest rate differentials, and the ability to hedge
exposure to exchange-rate risk.”

Answer 2: “To calculate overall returns on foreign financial assets, an investor needs to consider the initial spot exchange
rate used to convert their domestic currency into foreign currency, the interest earned on the foreign investment, and the
exchange rate at which the foreign currency is converted back into the domestic currency, either using a forward contract
or the future spot exchange rate.”

Answer 3: “Hedging (covered investment): The investor uses a forward exchange contract to lock in a future exchange
rate, eliminating exchange-rate risk. Speculation (uncovered investment): The investor waits and converts the foreign
currency back into the domestic currency at the future spot exchange rate, accepting the exchange-rate risk.”

Answer 4: “The forward premium is the proportionate difference between the forward exchange rate and the current
spot exchange rate. If the forward rate is higher than the spot rate, the currency is said to be at a forward premium, and if
lower, it is at a forward discount.”

Answer 5: “Their actions put pressure on exchange rates and interest rates:
• The spot exchange rate tends to rise as traders buy the foreign currency.
• The forward exchange rate tends to fall as traders sell the foreign currency forward.
• Interest rates in the foreign country tend to fall, and domestic interest rates tend to rise, narrowing the covered interest
differential.
Does Interest Parity really hold? Empirical Evidence

Evidence on Covered Interest Parity

• Covered Interest Parity (CIP): States that the forward premium should (approximately) equal the interest rate
differential between two currencies.

• Market Observable Rates: All required rates (spot, forward, interest rates) are available in foreign exchange and short-
term financial markets.

• Testing CIP: Testing CIP is straightforward using these observable rates.

• Comparable Financial Assets: Requires identifying comparable financial assets in different currencies for accurate
comparison.

• Low or No Default Risk: Ideally, assets used in testing should have minimal or no risk of default to avoid distortions in
results.
Before the Global Financial and Economic Crisis

Analysis Period: Focus on covered interest differentials from 1978

onward, following the shift to managed floating exchange rates.

Germany and Britain: Covered interest differentials were close to zero

from about 1985, staying within the range caused by transaction costs.

France: CIP held starting in 1987, after lifting capital controls that were
imposed earlier.

Capital Controls Impact: Early divergences (before mid-1980s) were

due to government-imposed capital controls limiting financial flows.

Germany and Britain Liberalization: Both countries removed capital The (annualized) covered interest differential is measured in favor of the United
controls by the early 1980s, allowing covered interest parity to hold. States, CD=F+iUS+iF , where F is the forward premium on the dollar and iF is the
interest rate for the other country (Germany, Britain, or France). The forward rate
and the interest rates are 90-day rates. The interest rates are for interbank
France's Political Risk: In 1981, election of socialist president borrowing in each country.
Mitterrand raised fears of stricter capital controls, leading to major CIP
deviations (over 6 percentage points).

Capital Liberalization in France: France eased capital controls in

1986, allowing CIP to hold from 1987 onward.
The Global Financial and Economic Crisis, the Euro Crisis, and After

Figure 18.3 shows covered interest differentials between

the U.S. and the euro area, Britain, and Japan from 2006
to 2021, using 90-day forward exchange rates and LIBOR
rates.

Before August 2007, deviations from Covered Interest

Parity (CIP) were small: the euro was within 0.07
percentage points, the pound within 0.12, and the yen
within 0.23.

However, following the onset of major financial crises and

changes in bank regulation, larger deviations from CIP
emerged.
The Global Financial and Economic Crisis, the Euro Crisis, and After

Global Financial Crisis (2007-2008):

• CIP deviations increased slightly after BNP Paribas' mortgage asset valuation issues in August 2007.
• After Lehman Brothers' collapse in September 2008, deviations widened significantly, reaching:
Over 2 percentage points for the euro and yen.
Over 3 percentage points for the pound.
• Deviations reduced by early 2009 but remained larger than pre-crisis levels.
Euro Crisis (2010-2011):
CIP deviations widened again to 1.5 percentage points for the euro in late 2011, due to fears of instability in Spain, Italy,
and the eurozone.
By early 2013, deviations returned closer to parity.
Causes of Large Deviations:
No government controls on capital flows; instead, banks were unwilling to exploit arbitrage due to high counterparty risk
during the crises.
Heightened fears of potential losses led banks to avoid engaging in covered interest arbitrage.
The Global Financial and Economic Crisis, the Euro Crisis, and After
Seasonal Pattern (2014-present):
• Since 2014, larger CIP deviations have occurred toward the end of each year, particularly for the euro, due to tighter bank
regulations.
• Banks reduce assets and liabilities near year-end, reducing arbitrage activity.
Post-2015 Observations:
• CIP continues to work reasonably well for major currencies but with wider deviations compared to pre-2007 levels.
• Deviations are now within a band of about 1 percentage point around parity, wider than the earlier range of 0.07 to 0.23
percentage points.
COVID-19 Pandemic (2020):
• CIP deviations jumped again due to the flight to safe financial positions.
• Deviations for the pound reached 0.6 percentage points, the euro 0.8, and the yen 1.4.
Evidence on Uncovered Interest Parity
Uncovered Interest Parity (UIP):
• UIP states that the expected rate of appreciation of a currency's
spot exchange rate should roughly equal the difference in interest
rates.
Testing Difficulty:
• Testing UIP is more complex than testing Covered Interest Parity
(CIP) because actual expectations of exchange rate changes are not
directly observable.
Method of Estimation:
• One approach to estimate UIP is to survey knowledgeable market
participants about their exchange rate expectations and assume
they respond truthfully.
• The average expected future spot rate can then be used to calculate
the expected appreciation and the expected uncovered interest
differential.
Study Findings (Figure 18.4):
• Results show that market participants often expected large
uncovered interest differentials for the U.S. relative to Germany and
Japan.
• This suggests that UIP does not hold as closely as CIP, indicating a
weaker relationship between expected appreciation and interest
rate differentials.
Evidence on Uncovered Interest Parity
Alternative Method for Testing UIP:
• Analyze actual returns on uncovered international investments to infer expected returns and exchange rate expectations.
Limitations of Individual Returns:
• The return on a single uncovered investment may not accurately reflect returns on comparable domestic investments due to
discrepancies between actual and expected future spot exchange rates.
Expected Returns and Parity:
• If expected uncovered returns are typically at parity, the actual uncovered differentials across numerous investments should
average to zero.
Research Findings:
• Studies show that actual uncovered differentials are not entirely random and often do not average to zero during certain
periods, indicating significant deviations from UIP.
Reasons UIP Does Not Hold Perfectly:
• Exchange rate risk is a major factor; investors require adequate compensation for the added risk of uncovered foreign
investments.
• Divergences from UIP reflect the necessary risk premium for exchange rate risk.
Exceeding Risk Premiums:
• Many studies conclude that uncovered interest differentials frequently exceed the risk premiums needed to compensate for
exchange rate risk.
Evidence on Uncovered Interest Parity
Bias in Expectations:
• If the uncovered interest differential exceeds the risk compensation, it suggests that market participants have biased
expectations regarding future spot exchange rates.
Market Inefficiency:
• Consistent biases in expectations may indicate that the foreign exchange market is inefficient.
Possible Explanations for Bias:
• Learning Process: Market participants may slowly learn about exchange rate behavior, leading to biased forecasts during this
learning phase.
• Anticipation of Sudden Shifts: Participants may expect a significant and abrupt change in exchange rates. Until this change
occurs, forecasts appear biased as they incorporate probabilities of a much different future rate.
Example of Devaluation Expectations:
• If a fixed-rate currency is expected to undergo a large devaluation, the expected value of the spot exchange rate in 90 days
would average between the current rate (if no devaluation occurs) and a significantly lower rate (if devaluation happens),
resulting in a biased expectation lower than the actual fixed rate.
Conclusions:
• Uncovered Interest Parity is empirically useful as a rough approximation but is not perfectly applicable to actual exchange rates.
Evidence on Forward Exchange Rates and Expected Future Spot Exchange
Rates
Forward Exchange Market and Speculation:
• In the presence of substantial speculation in the forward exchange market, the forward rate should align with the
average market expectation of the future spot exchange rate.
Relationship to Interest Parity:
• This concept, while seemingly different from interest parity relationships, is closely linked.
• If covered interest parity holds, testing whether the forward rate predicts the future spot rate is equivalent to testing
uncovered interest parity.
• The only distinction is that the current forward exchange rate is substituted with the expected future spot exchange rate.
Implications of Covered Interest Parity:
• For currencies and periods where covered interest parity applies, conclusions about the forward rate mirror those about
uncovered interest parity.
• The forward exchange rate serves as a rough indicator or predictor of the market's expected future spot rate.
Biases in Predictions:
• There are indications of biases in predictions of future spot rates derived from forward rates.
• Some biases may be due to risk premiums, while others stem from inherent inaccuracies in the forecasts.
Accuracy of the Forward Rate:
• The forward rate is not a particularly reliable predictor of future spot exchange rates; forecasting errors can be
substantial.
• In general, no method for forecasting exchange rates in the near future proves to be highly accurate.
Questions

Question 1: “What is Covered Interest Parity (CIP), and does empirical evidence support its validity?”

Question 2: “What is Uncovered Interest Parity (UIP), and how does it differ from CIP?”

Question 3: “What are the main factors that cause deviations from Uncovered Interest Parity (UIP) in empirical studies?”
Answers

Answer 1: Covered Interest Parity (CIP) suggests that the difference in interest rates between two countries is offset by the
forward premium or discount in their exchange rates. CIP implies that there should be no arbitrage opportunities in the
foreign exchange market when using forward contracts. Empirical evidence shows that CIP generally holds in practice,
especially in well-developed financial markets. This means that most of the time, the forward rate accurately reflects the
interest rate differentials between countries.

Answer 2: Uncovered Interest Parity (UIP) refers to the relationship between interest rate differentials and expected future
changes in exchange rates, without the use of forward contracts to cover the risk. According to UIP, currencies with higher
interest rates should depreciate in the future, equalizing returns across countries. However, unlike CIP, empirical evidence
shows that UIP does not always hold. Exchange rates do not always adjust as expected, making it riskier for investors who
don't hedge their investments.

Answer 3: Deviations from UIP occur due to several factors:

•Risk Premium: Investors demand a premium for holding riskier assets, which can cause exchange rates to deviate from
UIP predictions.
•Market Sentiment and Speculation: Investors' expectations and speculative behaviors often influence currency
movements in ways that UIP doesn't predict.
•Short-term Market Shocks: Sudden changes in monetary policy, political events, or economic data releases can cause
exchange rates to diverge from UIP expectations in the short term.