The success of the carry trade strategy has led to its widespread proliferation, despite the fact that it contradicts economic theory. In short, this strategy involves borrowing (going short) a currency with a relatively low interest rate and using the proceeds to purchase (going long) a currency yielding a higher interest rate, capturing the interest differential. It can be “enhanced” by employing leverage.
Uncovered interest parity (UIP) theory states that there should be an equality of expected returns on otherwise-comparable financial assets denominated in two different currencies. Thus, according to UIP, we should expect an appreciation of the low-yielding currency by the same amount as the return differential. However, there’s overwhelming empirical evidence against the UIP theory. Thus, we have what is known as the UIP puzzle.
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