| 
  • If you are citizen of an European Union member nation, you may not use this service unless you are at least 16 years old.

  • Stop wasting time looking for files and revisions! Dokkio, a new product from the PBworks team, integrates and organizes your Drive, Dropbox, Box, Slack and Gmail files. Sign up for free.

View
 

interest rate parity

Page history last edited by Brian D Butler 9 years, 7 months ago

 

 

 

 

 

 

 

 

Table of Contents:


 

Interest Rate Parity & the Fisher Effect

 

If the US increases their interest rates than the EURO, then you would expect the currency to appreciate, as more investors will want into the US.   And it does, but just for one day.  The longer term effect could be a depreciation. What happens is that investors immediately come in to catch the higher interest rate, but then extra risk yields to devaluation of the currency.  This is counter-intuitive, but has shown to happen quite often in the real world.  Think of it like this... the US had low interest rates for a long time, but a strong US dollar, but other countries had higher interest rates, but a weaker currency.  So, the higher interest rate didnt necessarily mean a long-term stronger currency.  It might help short term if the Fed were to increase the interest rate, but long term? no one knows.

 

 

 

 

International Fisher Effect

 

 

The International Fisher effect is a hypothesis in international finance that says that the difference in the nominal interest rates between two countries determines the movement of the real exchange rate between their currencies, with the value of the currency of the country with the lower nominal interest rate increasing.

 

To estimate future changes in FX rates...look at the difference in interest rates between the two countries. The country with the higher interest rate will see depreciation (their currency will depreciate). This is the opposite of what you expect. Normally, you hear that if the Fed raises interest rates, then the dollar will strengthen (appreciate) as investors will put money into the US in order to get the higher return. So, you would expect the dollar to appreciate. It does, but only in the very short term. Then, in the longer term, it will do the opposite, and depreciate. If you could have predicted the raise in interest rates, then you could have made money in the short term by investing in the currency before its quick appreciation, but as others pour in, the market will react, and it will be difficult to realize the gains in the future. What happens is that the forward / Futures market will price in the new information, and will drive the currency down. See the discussion below about "Interest rate parity in the Forward Market" for an explanation.

 

 

Interest rate parity in the Forward Market

 

This theory states that the difference between the spot exchange rate and the forward exchange rate must be set EXACTLY equal to the difference in the interest rates between two countries. If not, then a trader could make money risk-free arbitrage.

 

  • Example: if the US dollar is trading with the Brazilian currency (the Real) at a R$2.0 to $1 USD spot rate, and if the forward rate was also 2:1, then a smart person could convert their money to Reais today at 2-1 ratio, and purchase a 1 year bond (denominated in Reais) at a higher interest rate, and also purchase a forward contract to guarantee that they could convert their money back to USD at a 2:1 rate. It would be a guaranteed money maker. Everyone would want to do this because there would be no risk, and you could make a higher interest rate. So, no, the bankers are smarter than this, and they don't sell a forward contract at the same rate as the spot contract. Instead, what they do is sell the forward contract at the exact rate that would eliminate all incentive to exploit this system. What rate do they use? Its easy...they look at the difference in interest rates between the two countries, and then adjust the forward contract by this exact same amount. So, if Brazil offered 12%, and the US offered 10%, then the forward contract would have to adjust for the difference, or 2%. The Brazilian currency would have to decrease in value (depreciation) by 2%. So, the forward contract would be set at exactly R$2.04 to the $1 US dollar. In this case, the forward contract exactly offsets the advantage that an investor could get by moving their money into Brazil, so there is no arbitrage opportunity. The bank MUST set the forward rate this way.

 

  • Another Example (of how the forward rate is set using the spot rate + interest rates of two countries): if the sport rate today is $1.40 / Euro, and the USD interest is 11.3%, and Euro interest is 6%, then the forward contract rate should be set at $1.4742 to eliminate opportunities for arbitrage. How is this rate calculated? Its easy, you first subtract 6% from 11.3% to get 5.3%. This is the amount by which the USD must depreciate. In this example, the forward exchange rate of the dollar is said to be at a Discount because it buys fewer Euros in the forward exchange rate than it does in the spot exchange rate. The Euro is said to be at a Premium.

 

 

International Fisher Effect

 

The International Fisher effect is a hypothesis in international finance that says that the difference in the nominal interest rates between two countries determines the movement of the real exchange rate between their currencies, with the value of the currency of the country with the lower nominal interest rate increasing.

 

Problems with this theory

 

While it does explain how forward exchange rates are set, it has not proven to be very effective at predicting actual currency movements in the future. Contrary to the theory , currencies with high interest rates often appreciate rather than depreciate

 

 

 

 

Links

 

 

 

 

Comments (0)

You don't have permission to comment on this page.