One of the more popular strategies pursued by hedge funds is the currency carry trade. The strategy involves borrowing (going short) a currency with a relatively low interest rate and then using the proceeds to purchase (going long) a currency yielding a higher interest rate, thus capturing the interest differential. The strategy can be “enhanced” though the use of leverage.
The long-term success of this strategy has led to its proliferation, despite the fact that its superior performance is at odds with economic theory. Uncovered interest parity (UIP) theory suggests that the expected returns on otherwise-comparable financial assets denominated in two different currencies should be equal. So according to UIP, investors should expect an appreciation of the low-yielding currency by the same amount as the return differential.
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