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I will give an example of what I mean and please tell me what I'm missing because this can't be correct. For the sake of simplicity I will only use USD and EUR. So let's say that the central bank in the US raises interest rates. You buy USD with EUR and leave it there for let's say 1 year. You get your nice interest, and decide you want to buy a house in Europe, so you need euros.

Now what happened with the price in that time? Let's suppose the initial ratio was eur/usd=1. Because of the high interest rates on usd, it's value appreciated and eventually the ratio became say eur/usd=0.5. At that point you decide to sell your dollars for euros. Now, not only did you earn money because of the interest you got on USD, but now the exchange ratio also went your way, so isn't this a double whammy?

To use some numbers: you have 100 euros, you buy 100 usd. Interest is 100%, now you have 200usd. You earned money. You decide to buy euros again. Since eur/usd=0.5, with 200usd you buy 400 euros. You earn money again!

I know this is oversimplified but I would like to know the key point that I'm missing. Is it the uncertainty?

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  • $\begingroup$ Exactly right, double bonus. However had the exchange rate gone the other way, then you would have ended up with the same amount as the initial. Usually you would have hedged the currency, giving you no uncertainty around the exchange rate, and effectively given you the dollar interest on your euros. $\endgroup$ – ssn Feb 17 '18 at 22:06
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Yes, it’s the uncertainty. If you tried hedging the currency, the hedge would be generally such that there would be a loss that offsets the interest advantage. (This is known as covered interest rate parity. In oractice, there is a spread that causes behaviour to deviate from that -the currency basis. So you can lock in a small spread, but it is typically on the order of 10 basis points or less. During a financial crisis, the basis can get relatively large.)

If you do not hedge, the volatility in the currency rates over one year is normally greater than the interest rate differential. Buying a high interest rate currency is known as a carry trade. It is profitable until it isn’t. For an example, look at the Japanese yen in the early to mid-2000s. In that period, Japanese interest rates were the lowest in the developed world. It was thus a popular currency to short. It would then have periodic bursts where its value would shoot up, forcing shorts to cover.

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