Investors are often confronted with two distinct theories regarding interest rates and their behavior in the present and future. These are referred to as covered interest rate parity and uncovered interest rate parity. In both scenarios, investors are exchanging currencies in order to take advantage of seemingly advantageous interest rates in a foreign currency. The primary distinction between the covered and uncovered parity is the possibility for investors to take advantage of lucrative arbitrage opportunities. Arbitrage can be defined as profit made from the simultaneous buying and selling of one asset for different prices in different markets.
TL;DR (Too Long; Didn't Read)
The primary difference between the covered and uncovered interest rate parity is the incorporation of arbitrage into calculations.
Understanding Covered Interest Rate Parity
A covered interest rate parity is understood as a "no-arbitrage" condition. Simply put, this means that investors will be unable to achieve zero-risk profits simply by exchanging currencies and taking advantage of discrepancies in exchange rates. Under the terms of a covered interest rate parity, the possibility of arbitrage is eliminated by inducing a state of equilibrium between the the current interest rates and future contracts initiated simultaneously.
For example, if an investor is hoping to yield significant returns by transferring funds from a country with a 3 percent interest rate to a country with a 7 percent interest rate, a covered interest rate parity would require futures contracts to be implemented which, though the terms of the contract, eliminates all possibility of profit taking when funds are returned to the original currency.
Understanding Uncovered Interest Rate Parity
Unlike a covered interest rate parity, the possibility of arbitrage does exist in an uncovered interest rate parity due to the fact that futures contracts are not implemented at the time of the initial currency transfer. The uncovered interest rate parity relies on a form of innate and internal equalization in which it is assumed that the initial disparity between the interest rates of two countries will be equalized by changes in the value of those two country's currencies over time. Although the uncovered interest rate parity may accurately depict the behavior of the currency value, the possibility for arbitrage does exist if and when the conditions of the theory are not met.
With the covered interest rate parity, the possibility for arbitrage is concretely limited through the use of additional financial mechanisms. With that in mind, it could be argued that the primary distinction between the covered and uncovered parity is that the covered interest parity does not rely on abstracted theory in order to function, while the uncovered interest parity operates largely on assumptions made about a hypothetical economic model.
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