Can someone please explain why the investing curreny ends up depreciating?
I know you are supposed to borrow in the lower yielding currency (funding currency) and invest in the higher yielding currency (investing currency). But, I don’t understand why the higher yielding currency is supposed to depreciate. I would think, if anything, it would appreciate because you have a lot of people selling lower yielding currency for higher yiedling currency making lots of demand, hence appreciation! Any clarification woudl be helpful!
This is basically the uncovered interest rate parity. Say, we are given USD (2%) vs BRL (10%) and we have $1000. BRL/USD = 2 (using CFAI convention, Base = USD). Uncovered interst rate parity says that we should be indifferent between USD investing in 2% and BRL investing in 10% that is possible because BRL/USD rate will depreciate.
To support untrue’s point above, the carry trade assumes that the uncovered interest parity does NOT hold. What is implicit in the action of a carry trade is a “leap of faith”; hoping that the high yielding currency does NOT depreciate more than the excess return from holding high yield currency deposits. Since there is no arbitrage condition associated to uncovered interest parity, a yield currency doesn’t necessarily need to depreciate.
Under covered interest parity, there IS an arbitrage condition, so the high yielding currency should always depreciate relative to a lower yielding currency. We witness this in forward contracts as seen when we mark to market in chapter examples.
