I have been reading the economics for valuation chapter and there I read about the uncovered and covered interest rate parity relationships.
I know for a fact that during low volatility environments at least, hedge funds make money using the carry trade. Which violates the above theories.
If so, I would like to know how the hedge funds do it? In a practical sense of course.
Thank you.
If not mistaken, I remember a bunch of HF going bust when the Swiss revalued their currency, lol.
Might want to check that out.
the funds do it exactly how you see it in your text book. Uncovered interest rate parity does not always hold, if it doesnt you can make money via the carry trade. Or it can blow up in your face because you typically leverage it quite a bit
You cant violate covered interest rate parity, that will be arbitraged away almost immediately. Uncovered is a theory that states what should happen basically, but it doesnt always work out like that in real life.
One good example of parity getting assrammed is USD/EUR. ECB keeps buying assets, thus applying depreciation pressure to the Euro. On the other hand, the US Federal Reserve is tightening its policy, causing the USD to appreciate relative to Euro, despite the higher interest rates in the US.
Also, one should differentiate short term and long term effects of interest rate changes. If rates in the US increase, USD will appreciate immediately, not depreciate, due to inflows of people seeking higher returns. In theory, this will be offset later by depreciation, but this does not always happen, as we have already observed.
Another example is when there is an extreme difference in trade balance between two countries. For instance, back in 2010 or so, everyone was buying BRL currency, as the currency kept appreciating from foreign investment demand. On top of that, they were earning interest rates upwards of 10%, which was very high relative to JPY interest rates, or whatever they were short. Anyway, that trade eventually blew up as the Brazilian economy worsened.