A theory that relates current interest rates in two countries to the future value of the exchange rate for the currencies of those countries.
The theory is built on the assumption that interest rates reflect expectations of inflation while changes in exchange rates reflect realised inflation.
Suppose the three month US Treasury bill rate is 3 per cent and the Canada Treasury bill rate is 2 per cent. If the assumptions underlying the theory are true, we interpret the difference between US and Canadian rates (1 per cent) as the market’s estimate that over the next three months US inflation will exceed Canadian inflation by 1 per cent.
Furthermore, the theory predicts that the number of US dollars needed to buy a Canadian dollar will be 1 per cent greater in three months, given that the US dollar is expected to lose 1 per cent more of its domestic purchasing power than the Canadian dollar.
Some currency traders believe that uncovered parity does not hold and, therefore, there is a trading opportunity: borrow Canadian dollars at 2 per cent, change them to US dollars, deposit those US dollars at 3 per cent, and, three months later, the US dollar is higher and the Canadian dollar loan can be paid back with money to spare - an arbitrage profit (see carry trade).
This strategy can indeed sometimes profit when the money and currency markets violate uncovered parity. However, the returns are very uncertain and some investors and academics believe any earnings are compensation for bearing risk rather than a true arbitrage profit.