for much of this period. This transaction is known as covered interest rate arbitrage. What is 'Uncovered Interest Rate Parity (UIP. Hedging exchange risk (again, with the benefit of hindsight) in this case would have mitigated at least part of that dismal performance. Assume that the interest rate for borrowing funds for a one-year period in Country A is 3 per annum, and that the one-year deposit rate in Country B. In that case, if they had been fully hedged over the period mentioned above, they would have foregone the additional 102 gains arising from the Canadian dollars appreciation. An understanding of forward rates is fundamental to interest rate parity, especially as it pertains to arbitrage (the simultaneous purchase and sale of an asset in order to profit from a difference in the price). During most of this period, the Canadian dollar appreciated against its.S.
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Total returns from Canadas benchmark S P/TSX equity index from 2002 to August 2008 were 106, or about.5 annually. Converts the borrowed amount into Currency B at the spot rate. Uncovered Interest Rate Parity, uncovered interest rate parity (UIP) states that the difference in interest rates between two countries equals the expected change in exchange rates between those two countries. The anomaly may be partly explained by the carry trade, whereby speculators borrow in low-interest currencies such as the Japanese yen, sell the borrowed amount and invest the proceeds in higher-yielding currencies and instruments. Theoretically, if the interest rate differential between two countries is 3, then the currency of the nation with the higher interest rate would be expected to depreciate 3 against the other currency. It appreciated against the.S. In reality, however, it is a different story. Of course, at the beginning of 2002, with the Canadian dollar heading for a record low against the.S.