Uncovered Interest Parity: why currency with higher rate depreciates?

Suppose the spot exchange rate quote is ZAR/EUR = 8.385. The 1-year nominal rate in the eurozone is 10% and the 1-year nominal rate in South Africa is 8%. Calculate the expected percentage change in the exchange rate over the comling year using uncovered rate parity.

The answer to this problem is:

The rand interest rate is less than the euro interest rate, so uncovered interest rate parity predicts that the value of the rand will rise (it will take fewer rand to buy one euro because of higher interest rates in the eurozone. The eyri (the base currency) is expected to “appreciate” by approximately Rzar - Reur = 8% - 10% = -2%. Thus the euro is expected to depreciate by 2% relative to the rand, leading to a change in exchange rate from 8.385 ZAR/EUR to 8.217 ZAR/EUR over the coming year.

My challenge:

I don’t get my hear around the fact that the currency with the higher rate (here EUR) depreciates. I thought that if EUR pays 10% and ZAR 8%, people would want to sell ZAR and by EUR which would have meant the EUR appreciates. Obviously I am getting this wrong so any insight would be appreciated.

Cheers

In reality, traders would do that (borrow in ZAR and invest in EUR). But the question here is asking you to calculate the expected percentage change using uncovered interest rate parity (UIRP).

UIRP works under a no-arbitrage assumption. So, if EUR interest rate is 10% and ZAR interest rate is 8%, and UIRP holds, then EUR is expected to depreciate by 2%, in order for the arbitrage-free assumption to hold (i.e. traders doing carry trades would earn nothing on this strategy).

FTFY

In reality, I see no reason for UIRP to hold; i.e., I see no economic force that would cause exchange rates to move in the direction of interest rate parity.

:cowboy_hat_face:

Learnt a new abbreviation today