Covered and uncovered parity: how interest differentials pin down forward exchange rates.
Warming up the engine…
No-arbitrage across currencies: interest differentials must equal expected (uncovered) or forward-locked (covered) currency depreciation.
CIP: F/S = (1+i)/(1+i*); UIP: i − i* ≈ expected depreciation
If yen deposits pay 1% and dollar deposits 5%, the dollar must be expected to fall ~4%, otherwise money floods one way until prices move. CIP holds almost exactly (it's enforced by arbitrage); UIP fails often enough to fund the carry trade.
Keep covered vs uncovered straight: CIP uses the forward rate (riskless), UIP uses expectations (risky).
Now prove you have it
Move the curve to where you think it lands, and get told exactly which part you got right.
Real-world scenarios on this model
Also in Trade & Open Economy
Equilibrium at E 50, R 5.0.
Equilibrium: E* = 50.0, R* = 5.0
Current equations
Money chases the best return across borders. The flat line is what home deposits pay; the downward curve is what foreign deposits are expected to pay once you convert currencies both ways. The exchange rateexchange rateThe price of one currency in terms of another. settles where the two returns are equal.