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Looking at forward rates, the exchange rate for the currency with the higher interest rate gets worse over time. This makes sense or else there would be an arbitrage opportunity to borrow in the low rate currency, convert, lend in high rate, and buy a forward contract to eliminate currency risk. However, this doesn't make sense given that low interest rates tend to increase inflation and weaken a currency while high rates do the reverse. This implies that the low rate currency should weaken relative to the high rate currency, leading to better exchange rates for the high rate currency over time, not worse. Why is this?

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  • $\begingroup$ Does this answer your question? economics.stackexchange.com/questions/13864/… $\endgroup$
    – Art
    Nov 4, 2019 at 5:08
  • $\begingroup$ @Art It seems to be on the same topic, but it doesn't directly answer my question (or I'm not understanding it). My question is how to reconcile UIP with the idea that low interest rates increase inflation and weaken a currency (and vice versa for high rates). $\endgroup$ Nov 5, 2019 at 15:14

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