Abstract
The uncovered interest parity (UIP) hypothesis postulates an equilibrium relationship between the market’s expected rate of change of the spot exchange rate and the interest rate differential on perfectly substitutable domestic and foreign assets. This hypothesis stipulates that if the interest rate differential is different from the expected rate of change of the exchange rate, risk neutral agents tend to move their uncovered funds across financial markets until equality is re-established. Under the joint assumption of risk neutrality and rational expectations, another hypothesis can be derived from the CIP and UIP conditions which postulates that the forward rate (the forward premium) is equal to the market’s expectation of the future spot exchange rate (the expected rate of change of the spot exchange rate), implying (unbiased) efficiency in the forward exchange market.
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