Survey of Literature on Covered and Uncovered Interest Parities

I. Basic Concepts

In a fully integrated world with perfectly competitive profit maximizing agents
and no transactions costs, the following Covered Interest Parity (CIP) condition would
hold in equilibrium:

F

(1 + it ) = (1 + i*) F^t-            (1)

S_t

Where it and it* are respectively returns on comparable domestic and foreign
assets between time t and t+1, St is the domestic currency price of foreign currency, Ft is
the forward rate or the next period domestic currency price of foreign exchange delivered
next period. Since all the variables in the above equation are known a priori, any
deviation from this parity in our model world represents pure profits and therefore cannot
exist in equilibrium. In addition, assuming risk neutral rational agents implies that
forward rate would equal the expected future rate therefore, the Uncovered Interest Parity
(UIP) condition must also hold in equilibrium:

S^e

(1 + it ) = (1 + i*) -ɪ         (2)

S_t

However, in a world with oligopolistic players in financial markets,
underdeveloped money markets, exchange or capital controls or risk of such controls,
differential taxation, limited supply of capital, sovereign immunities, transaction costs
and other inconveniences, forward rate may differ from current spot rate by more than the
interest differential and moreover, it may differ from expected future spot rate [Keynes,
1923; Dooley and Isard, 1980; Frankel 1992; Frenkel and Levich (1975)]. The former
difference has been estimatedby several studies (reviewed below) for industrial countries

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