The Uncovered Interest Rate Parity - A Literature Review

Abstract

Interest rates and exchange rates are considered to be one of the most discussed areas in International Finance. When considering the main theories that explore on these two variables, Uncovered Interest Rate Parity (UIP) states that the interest rate differential is an unbiased predictor of the spot exchange rate changes. The impact on investors’ attitude is that they would be indifferent towards the returns on domestic and foreign assets denominated in same currency thereby eliminating any short term arbitrage profits. Studies of this nature are of significance in the case of Sri Lanka, as a country which is trade dependent accurate forecasts of exchange rates would be of immense importance. Hence this study focuses on reviewing what is revealed by literature so far and what is not.

Keywords: Interest Rates, Exchange Rates, Uncovered Interest Rate Parity (UIP)

JEL Classification: F00, F31