I’m having a hard time understanding the difference between the two and the answer to the following question in this year Wiley mocks.
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“The manager believes that inefficiencies occur in the foreign exchange markets that can be exploited** to generate excess return consistently over the long term. One of the major strategies that we have been employing successfully over the past few years is exploiting forward rate bias through the carry trade executed in currency forward markets.”**
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Based on the notes made by Guscott about management of the GEIG Fund, it is most likely that the fund is profiting from which of the following parity relations not holding?
A. Covered interest rate parity. B. Uncovered interest rate parity. C. Purchasing power parity.
Answer: B
Uncovered interest rate parity is a theory that predicts that high interest rate currencies should weaken such that investors get the same returns regardless of the currency their deposits are held in. If this theory held, then the carry trade, which involves depositing in high‐interest‐rate currencies and borrowing in low‐interest‐rate currencies, would never work since interest rate differentials would be offset by foreign exchange rate movements. Answer A is incorrect since covered interest rate parity is a no‐arbitrage law for pricing futures contracts and hence is not used to predict where exchange rates will move to. Answer C is incorrect since purchasing power parity predicts that exchange rates are driven by inflation differentials.