# Uncovered Interest Rate Parity Definition and Calculation

## What is Uncovered Interest Rate Parity?

Uncovered Interest Rate Parity (UIP) is an economic concept that relates to the relationship between interest rates and exchange rates in international financial markets. It is a theory that suggests that the difference in interest rates between two countries should be equal to the expected change in the exchange rate between their currencies.

According to UIP, if the interest rate in one country is higher than in another country, investors will move their funds to the country with the higher interest rate, leading to an increase in demand for that country’s currency. This increased demand for the currency will cause its value to appreciate, resulting in a decrease in the exchange rate.

Conversely, if the interest rate in one country is lower than in another country, investors will move their funds away from the country with the lower interest rate, leading to a decrease in demand for that country’s currency. This decreased demand for the currency will cause its value to depreciate, resulting in an increase in the exchange rate.

Uncovered Interest Rate Parity is based on the assumption that investors have perfect information and can accurately predict future exchange rate movements. However, in reality, this assumption may not hold true due to various factors such as political events, economic indicators, and market sentiment.

## Definition and Calculation

Uncovered Interest Rate Parity (UIP) is an economic theory that suggests there is a relationship between interest rates, exchange rates, and expected returns on foreign investments. According to UIP, the difference in interest rates between two countries should equal the expected change in the exchange rate between their currencies.

The calculation of Uncovered Interest Rate Parity involves comparing the interest rates of two countries and the expected change in their exchange rates. The formula for calculating UIP is as follows:

UIP = (1 + i) / (1 + i*) * (Ee / E)

Where:

• i is the interest rate in the domestic country
• i* is the interest rate in the foreign country
• E is the current exchange rate
• Ee is the expected future exchange rate

If the UIP equation holds, the UIP value will be equal to 1. If the UIP value is greater than 1, it suggests that the domestic currency is expected to appreciate, and if the UIP value is less than 1, it suggests that the domestic currency is expected to depreciate.

Uncovered Interest Rate Parity is based on the assumption that investors are risk-neutral and have perfect information. However, in reality, there are various factors that can affect exchange rates and interest rates, such as inflation, political stability, and economic indicators.