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I am aware of the details of Uncovered Interest Parity, namely that the expected depreciation of a currency vs another one should equal the interest rate differential. I am also aware that empirically it doesn't seem to hold.

However, my question is by what mechanism should this parity be achieved? As in, if the currency appreciates, what incentivises traders to push it downwards?

Edit: One explanation is that after the initial increase in the interest rate differential, investors invested in the relatively higher yielding currency and bid it up. This pressured interest rates lower and investors don't invest as much now because the interest differential is less attractive.

I don't see how that leads to a selling of the currency though. Is it because the drop in the differential induces selling of the currency?

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  • $\begingroup$ The mechanism is Arbitrage. Explanations about why it doesn't hold empirically usually involvr stories about limits to arbitrage. $\endgroup$ – BB King Mar 16 '17 at 21:44
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    $\begingroup$ Possible duplicate of Interest rate parity: Counter intuitive $\endgroup$ – Alecos Papadopoulos Mar 17 '17 at 18:51
  • $\begingroup$ Edited original question $\endgroup$ – SocraticParadox Mar 18 '17 at 23:05

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