The U.S. interest rate is 6% and Japan's is 1%. An investor has two options: (A) invest in U.S. assets at 6%, or (B) convert dollars to yen, earn 1% in Japan, and lock in today's forward exchange rate to convert back. Under covered interest parity, what should the relationship between these options be?
AOption A earns more because the U.S. rate is higher
BBoth options yield the same return after accounting for the forward rate adjustment, because any difference is eliminated by arbitrage
COption B earns more because Japan's lower rate signals a stronger yen appreciation
DThe comparison is invalid because forward contracts introduce credit risk that makes returns incomparable
Under CIP, the forward exchange rate adjusts so that the dollar return from the round-trip in yen (earn 1% + gain from forward premium) exactly equals 6%. If it didn't, arbitrageurs would borrow in the low-return currency, invest in the high-return one, and lock in the forward rate for a riskless profit — and their trading would push the forward rate back into alignment. CIP is a no-arbitrage condition: any deviation is a riskless profit opportunity and gets eliminated almost instantly in liquid markets. The forward rate is the mechanism of equalization.
Question 2 Multiple Choice
Why does uncovered interest parity (UIP) fail empirically more often than covered interest parity (CIP)?
ACIP applies only to major currency pairs; UIP applies to all currencies including emerging markets where it frequently fails
BCIP involves contractually locked-in forward rates, so any deviation is a riskless arbitrage profit that traders eliminate instantly; UIP relies on exchange rate expectations that can be systematically wrong
CCIP uses spot exchange rates, which are more liquid and therefore more accurately priced than the future rates UIP depends on
DUIP assumes rational investors; CIP does not, making CIP hold regardless of investor behavior
CIP is enforced by riskless arbitrage. With observable spot rates, forward rates, and two interest rates, any CIP deviation can be locked in immediately for a guaranteed profit — it gets traded away. UIP substitutes the expected future spot rate for the forward rate, and expectations can be wrong — and may be systematically wrong for extended periods. The famous 'forward premium puzzle' shows that currencies with higher interest rates often appreciate rather than depreciate (the opposite of UIP's prediction), generating persistent carry trade profits. This systematic failure reflects risk premia, peso problems, or behavioral factors that CIP arbitrage does not face.
Question 3 True / False
If a country raises its interest rate, uncovered interest parity predicts that its currency will depreciate over the period that the higher rate is in effect.
TTrue
FFalse
Answer: True
UIP requires that the expected return to investing in either currency be equal. If Country A raises its interest rate above Country B's, investors will move capital to A, bidding up A's currency — but UIP predicts this appreciation already happened or will happen immediately, after which the currency is expected to depreciate back toward its original level at a rate equal to the interest differential. In the UIP framework, the higher interest rate is the reward for holding a currency expected to depreciate, not an ongoing advantage. This is why UIP predicts depreciation for high-rate currencies — the gains must be offset by currency loss.
Question 4 True / False
Persistent violations of covered interest parity in liquid, major-currency markets indicate that investors have incorrect expectations about future exchange rates.
TTrue
FFalse
Answer: False
CIP has nothing to do with exchange rate expectations — it uses forward rates, which are contractually fixed prices, not forecasts. A CIP deviation is a riskless arbitrage opportunity available right now with known, locked-in payoffs. Persistent CIP violations therefore do not reflect forecast errors but rather a breakdown in the ability of arbitrageurs to implement the trade — typically due to balance sheet constraints, counterparty credit risk, or funding liquidity stress in the banking system. The CIP violations that appeared in the 2008 financial crisis and the 2020 COVID shock reflected banks' inability to freely intermediate the trade, not mistaken expectations.
Question 5 Short Answer
Explain the key difference between covered and uncovered interest parity in terms of what 'enforces' each condition. Why is CIP nearly always satisfied in liquid markets while UIP often fails?
Think about your answer, then reveal below.
Model answer: CIP is a no-arbitrage condition enforced by riskless, immediate trading. Using a forward contract eliminates all exchange rate uncertainty: you lock in the conversion rate today, so the round-trip return is calculable in advance with no risk. Any deviation can be exploited for guaranteed profit, so arbitrageurs eliminate it quickly in liquid markets. UIP is an equilibrium condition enforced only by investor expectations about future spot rates. There is no riskless trade to enforce it — if your expectation is wrong, you lose. Expectations can be systematically biased (risk premia, peso problems), and no one can force the exchange rate to move as predicted. The result: CIP is near-perfect in liquid markets; UIP holds at best approximately and often fails over short horizons.
This distinction generalizes beyond currency markets: any condition enforced by observable, riskless arbitrage (like the law of one price for identical goods in frictionless markets) will hold tightly, while conditions enforced only by rational expectations will hold loosely and fail whenever expectations are distorted by risk, uncertainty, or behavioral biases. Understanding which type of condition you are dealing with is the key to predicting when parity relationships will hold.