Question on covered and uncovered interest rate parity that seems to keep coming up and confusing me. For interest rate parity to hold the currency with the higher risk free interest rate would need to trade at a forward discount to the currency with the lower risk free interest rate. This is a little counter intuitive to me. If a currency has a higher risk free interest rate, wouldn’t investors buy that currency and push the value of the currency up, leading to currency appreciation, not depreciation? I understand that for the no arbitrage condition to hold that the currency with the higher currency would have to depreciate. What I do not understand is why, in the real world, this relationship holds. Why would investors not bid up the price of the higher interest rate currency causing it to appreciate relative to the lower interest rate currency?
i think with the assumption that both country is identical in every way, a higher risk free interest rate does not indicate that country is better in any way shape or form, thus investors should expect a lower forward rate.