The question arises as to what particular interest rates are used to calculate the interest parity.
Foreign-exchange markets operate under a state of "covered interest parity".
Main applications: Sovereign debt and default; Financial crises and sudden stops; Hedging, interest parity relationships, and the determination of exchange rates; Liability dollarization.
The strategy was originally designed for equity markets, but it also generates abnormal returns when applied to uncovered interest parity deviations for five countries.
A twist or two of Basel How to spend it Bye-bye EMBI Carry on speculating ReprintsHowever, economic theory also suggests that "uncovered interest parity" should operate.
There have been times, and even rather prolonged periods, in which the forward rate for a currency has fallen below (or risen above) its interest parity.
In previous times the rate of interest on U.S. Treasury bills and the rate of interest on British Treasury bills were used to determine the interest parity of the sterling price for forward dollars.
In other words, the forward rate should be a good guess of the likely future spot rate.In the real world, uncovered interest parity has not applied over the past 25 years or so.
When the relation of the forward rate to the spot rate is determined by a comparison of the short-term interest rates in the two centres in the manner just described, the forward rate is said to be at "interest parity".
Nonetheless the demand for forward sterling has to be kept equal to the supply of it, and if there is insufficient arbitrage for this purpose then a positive profit has to appear on the purchase of forward sterling; in other words, its price has to fall below the interest parity.
