Interest rate differentials and currency movement

[archived_user]

The text describes the relationship of interest rate differentials and currency movement can reflect several factors:
• If a currency is substantially overvalued and expected to decline, bond interest rates are likely to be higher to compensate foreign investors for the expected decline in the currency value.
Any kind soul can help explain this observation please? Not sure if its related to the uncovered interest rate parity derives the expected future spot rate from level II, although that’s counter-intuitive to explain the above as uncovered interest rate parity predicts expected future spot rate due to interest rate differentials.
Thank you.

 

[archived_user]

Interest rate parity does not predict expected future spot rates based on interest rate differentials.
Interest rate parity does exactly what its name implies: it describes what the future spot exchange rate has to be if there is to be parity between the following transactions:

• Invest in currency A at the currency A risk-free rate
• Convert currency A to currency B at the spot exchange rate, invest in currency B at the currency B risk-free rate, convert currency B to currency A at the future spot exchange rate

Interest rate parity simply describes what the future spot rate must be to eliminate an arbitrage opportunity today. What the future exchange rate will actually be isn’t relevant to interest rate parity.
The text you quote above simply says that there are factors other than interest rate parity that affect exchange rate movements, and that at least one of them – supply and demand for currency – tends to push exchange rates in the opposite direction than the one that interest rate parity would suggest.
In short, it’s a complicated world.

 

[archived_user]

I think it is much simple than it looks.
Foreign Exchange Carry Trade
This investment strategy consists in taking advantage of interest rate differentials between currencies. If I can borrow at 2% in currency A and invest at 10% in currency B, I would be able to gain 8% as long as exchange rate doesn’t move in the future. As Magician said above, the process includes exchanging currencies at spot rates in T0 and T1.
So, how much must the spot exchange rate change be (Var%) to not depredate my interest rate gap? In my example, if currency B depreciates 8%, then my net gain would be 0%.
If we already know by strong facts that currency B is overvalued, then it is likely it is going to devaluate. How much? We don’t know exactly. However, as an investor I would demand a higher interest rate in B currency to decrease the probability of getting a negative gap of interest rates.
Hope this helps!