Uncovered Interest Rate Parity vs International Fisher

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Damil4real

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Uncovered Interest Rate Parity - a parity condition stating that the difference in interest rates between two countries is equal to the expected change in exchange rates between the countries’ currencies.
International Fisher - states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries’ nominal interest rates for that time.
I mean, how do you know the difference between this two theories?
An investor wants to relate interest rate differentials to exchange rate movements. An appropriate method to use will be:
A) Uncovered Interest Rate Parity
B) International Fisher
Please explain.
 
A
because the fischer is also concerned with inflation differences.
Your question, only refers to in rate differentials with no mention of inflation differentials.
 
Fisher has embedded both inflation and interest rate parity.
“Uncovered” Int. Par. as the name suggests is only interest parity.
 
International Fisher is only Inflation to Interest Rate, isn’t it?
There is no Exchange rate anywhere out there… so by default it becomes a wrong choice for the above question…
 
cpk123 Wrote:
——————————————————-
> International Fisher is only Inflation to Interest
> Rate, isn’t it?
>
> There is no Exchange rate anywhere out there… so
> by default it becomes a wrong choice for the above
> question…
International Fisher - states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries’ nominal interest rates for that time.
 
Damil
International Fisher states - Interest Rates differential = Inflation Differential…
and nothing to do with the exchange rates.
Please check again…
What you are stating is the Interest Rate Parity Relation above.
 
Damil,
Fisher, i think, also says that real interest rates are the same across the whole world. so in the end it is talking about how inflation rates change the exchange rate.
They are two different theories, don’t try to connect them together. I think you might be trying to find a big picture theory but there is none here.
Fisher has to do with inflation and uncovered has to do with interest rates
i might be completely wrong
 
Do this:
Covered Interest Rate Parity - meaning FX position covered with FWD hedge it predicts expected FWD rate (FWD rate as explained by NOMINAL interest rate)
Then you also have relative PPP, which states the relationship between the INFLATION rate and expected SPOT rate
after that , take Fisher, for it to hold the assumption is that long run real interest rates are the same across all countries, so the only reason for difference in nominal rates is inflation, from that you get that inflation is proportional to nominal interest rates
then using that , you take fisher and PPP, and replace inflation in PPP with nominal interest rate (the ration will be the same), and that give you UNCOVERED IRP - uncovered because of no forward hedging, so it predicts , same as PPP - expected future spot rate
therefore, due to the above fisher assumptions, you conclude that covered and uncovered interest rate parties yield the same result, so FWD rate is unbiased predictor of future Spot rate since all the above formulas - PPP , UIRP and CIRP give you the same result. (not true in practice since short term fisher doesn’t hold and there is FWD premium that you pay if you want to hedge vs expected spot rate).
all on p 335-337 book 1
 
Hotdawg, this is a nice explanation. Just attempting to give it a further perspective.
In your Covered Interest Rate Parity, the idea is to establish a Forward Rate. Here, all the inputs are known, meaning nothing is left for prediction. That is, risk-free interest rates for both currencies in the pair are known and current spot rate for the pair is ofcourse known. So, the forward rate is nothing but a mathematical calculation and nothing is left for chance. Rationale is to avoid any arbitrage opportunities.
Now, the world would not have any problems :) if the calculated Forward Rate available for us for hedging our transactions, exactly predicted our future spot rate. That way any hedging using the only available Forward Rate would be 100% effective. But, unfortunately, that is not the case. That is, even as we are hedging using the available Forward Rate, we already know that expected spot rate is different from this Forward Rate.
And how do we know that? That is by using Uncovered Interest Rate Parity relation. This uncovered parity relation uses estimated Interest Rates (as against known interest rates previously).
And how does is estimate those Interest Rates? By using Fisher Relation. Fisher Relation assumes that Real Interest Rates are same across the world, so just by estimating Inflation in a particular economy, we could estimate Nominal Interest Rate for the respective currency.
And how do we estimate Inflation? By using Purchasing Power Parity, using prices either for a single good (absolute PPP) or using prices for basket of goods (relative PPP).
So, uncovered Interest Rate Parity is a combination of PPP (to estimate inflation) and Fisher Relation (to use that inflation to estimate Interest Rate). It is called ‘Uncovered’ because there are no dealers in the market who will provide this Expected future spot rate for us to hedge our transactions. And it is still called ‘Interest Rate Parity’ as it is still using Interest Rates (although estimated) to predict future spot rate.
Hope it gives some more perspective to the whole thing.
 
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