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FRM Part I · FRM Exam Part I · Foreign Exchange Markets

Which of the following is the most common empirical finding regarding uncovered interest parity in the foreign exchange market?

High-interest-rate currencies have often not depreciated by enough to offset the interest differential, so UIP fails empirically. This is why carry trades have earned positive average returns, although with the risk of sharp crashes.

  1. AHigh-interest-rate currencies tend to depreciate by the full interest differential
  2. BHigh-interest-rate currencies have often not depreciated enough, which supports carry trade profits on averageCorrect
  3. CForward rates are perfect predictors of future spot rates
  4. DInterest differentials have no relation to forward premiums

Explanation

Empirical studies find UIP frequently fails; high-yield currencies often do not depreciate as much as predicted, and sometimes appreciate, which gives carry trades positive average returns with crash risk. Option A is what UIP predicts, not what is found. Option D is wrong because covered parity links differentials to forward premiums.

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