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Why would we not expect uncovered interest parity to hold for two international financial instruments with...

Why would we not expect uncovered interest parity to hold for two international financial instruments with differing terms to maturity?

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Answer #1

Uncovered Interest Parity is a non-arbitrage condition which postulates that there would be no arbitrage possible in case of a domestic currency borrowing or a foreign currency borrowing. In the case of 2 instruments of differing terms to maturity we would not expect this to hold due to different levels of risks in the 2 instruments. The risk variation will be in terms of liquidity, maturity and default. Hence the basic assumption of risk neutrality will be violated causing an opportunity for arbitrage and violation of uncovered interest parity condition.

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