Table of Contents:
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.
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.
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.
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.
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