According to the uncovered interest rate parity, one of the assumptions is that investors are risk neutral. But why is that? Arent they considered more risk lover because they are not hedging any currency risk ?
The uncovered interest rate parity says that the expected spot rate will be equal to the interest rate differential of the two countries in question. Lets assume that we have USA which offers 5% interest rate and Europe 10%, and the European currency is the base currency. One year from now, we expect the European currency to depreciate against the American one, but usually when when one country has higher interest rate, doesnt it mean that more and more people are willing to invest in that country, hence demand more of the European currency?
Not hedging currency risk simply means that they’re not risk averse.
There are many forces that affect currency exchange rates.
Interestingly, there is no reason (that I have . . . um . . . uncovered) that uncovered interest rate parity should hold.