The carry-trade strategy involves borrowing (going short on) a currency with a relatively low interest rate and using the proceeds to purchase (going long on) a currency yielding a higher interest rate, capturing the interest differential. The strategy can be “enhanced” though the use of leverage.
The success of this strategy has led to its proliferation, despite it being at odds with economic theory. 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 an overwhelming amount of empirical evidence against UIP theory. Thus, we have what is known as the “UIP puzzle.”
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