Interest Rate Stuff
Relates Interest Rates and Exchange Rates via a non-arbitrage condition.
From Wikipedia: returns from borrowing in one currency, exchanging that currency for another currency and investing in interest-bearing instruments of the second currency, while simultaneously purchasing futures contracts to convert the currency back at the end of the holding period, should be equal to the returns from purchasing and holding similar interest-bearing instruments of the first currency. If the returns are different, an arbitrage transaction could, in theory, produce a risk-free return.
In other words:
- Borrow USD
- Convert USD to EUR
- Invest EUR
- Own futures contract to convert back from EUR to USD
- A relationship between spot exchange rates, expected spot, and nominal interest rates.
- Expected Spot Rate = Spot * (1+r_counter)/(1+r_base)
- Difference from Covered Interest Rate Parity : future spot rate is NOT known, so Uncovered simply provides an estimate of change in the spot.