FX · Core
Interest Rate Parity
Interest-rate parity links interest differentials to forward FX — covered IRP is an arb; uncovered is a hypothesis the carry trade fades.
Definition
Covered: F/S = (1+i_d)/(1+i_f) (up to conventions). Violations after costs are CIP basis — a balance-sheet price since 2008. Uncovered: the interest gap equals expected spot change; empirically, carry often wins until it does not.
Why it matters
Forwards are priced off CIP. Cross-currency basis is the living violation. UIP is why carry exists as a factor.
Case
Post-GFC EUR/USD basis: dollar funding premia made CIP fail in size. The ‘arb’ needed a bank balance sheet you did not have.
How to read it
Covered vs uncovered. If you see a CIP gap, ask who is constrained. If you see a UIP gap, you are looking at carry.
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