Describe what the Covered Interest Parity (CIP) and Uncovered Interest Parity (UIP) conditions are and highlight their differences.

These are two arbitrage relations expected to hold in an international setting where capital can flow freely between different countries. In particular, the two conditions arise when investors can choose freely and costlessly between investing their domestic currency in a domestic bank at the domestic interest rate or exchanging their domestic currency for foreign currency, investing in a foreign bank at the foreign interest rate and at the end of some period, exchange their funds back to the domestic currency and bring them back home. UIP states that, in expectation, the returns to these two alternative strategies should, by arbitrage, be the same. Covered interest parity, rather than relying on exchange rates in the future equalling their expected value, employs a forward contract by which the investor can exchange his funds at a set rate next period. As such, CIP involves no uncertainty. In practice CIP holds. Indeed, CIP is how financial institutions selling forward contracts for currencies set their forward rates.
UIP on the other hand is found rarely to hold in the short run. While it predicts that any gains resulting from one country having a higher interest rate than another should be wiped out by a countervailing change in the exchange rate (e.g. if US interest rates are relatively high relative to eurozone rates, the US dollar is expected to depreciate relative to the euro: one dollar is expected to buy fewer euro next year) in practice, exchange rates often move in the opposite direction to that predicted by UIP, enhancing the gains of people borrowing in the low interest rate currency and saving at the higher foreign rate. This gives rise to an investment strategy known as the international carry trade.