In the Mundell-Fleming model, a currency with higher interest rates will appreciate due to extra demand for that currency, to take save with the higher rates (carry trade). I understand this part.
But in the sections on interest parity it seems a currency with higher interest rates can be expected to depreciate.
have I read this right?
why would it depreciate? I’m looking for an intuitive understanding
Yes.
Interest rate parity.
Arbitrage requires that forward exchange rates follow interest rate parity.
However, as you’ve discovered, there are forces other than interest rate parity that affect exchange rates.
Hmm, I’m pretty inexperienced but it seems quite rare in finance in 2015 to have two convincing concepts with opposite conclusions. Do you have a feeling this area will benefit from future research or will we be stuck with the current theories?
It’s almost like there’s two layers of arbitrage: technical arbitrage from CIRP, and kind of fuzzy arbitrage from the expectation of carry trade participation.
Need to read more.
There’s nothing wrong with two concepts with opposite conclusions: there are multiple forces acting on exchange rates; there’s no reason to assume that all forces act in the same direction.
When you buy or sell an asset, there are two forces acting on the price: a seller who wants it to be higher and a buyer who wants it to be lower. So it is with interest rate parity and currency demand. Sometimes one force is stronger, sometimes the other is, and sometimes they balance. Nothing odd about it.
Carry trade, by the way, isn’t arbitrage: there’s risk.
If in a simple world there’s only 2 pressures:
D = downward pressure from CIRP
U = upward pressure from carry trade participants
If these are the only two factors (unrealistic) and both are positive (realistic?), there is an arbitrage opportunity to earn U.
So then it’s a matter of estimating the billion other factors involved
thats really the whole point of the study session.
you need to know how all the various forces change FX rates. if you set up a carry trade you want to invest in a higher yielding and strengthening currency. it’s not good to invest in one which is experiencing capital flight.
There is an arbitrage opportunity to earn U only if you can guarantee earning U. Arbitrage is, by definition, risk-free.
The point is, you cannot guarantee it. Thus, it’s not arbitrage.
Strengthening _ relative to interest rate parity _; not necessarily strengthening absolutely.
Yep, arbitrage is the wrong word. More like a whiff of a profit opportunity, dependent on all the other factors equally zero or moving in the same direction as U.
I guess maybe start with the currency pair with the most balanced commercial usage
That’s just my question: What ‘force’ causes a currency with a high interest rate to depreciate? The answer seems to be, there isn’t a definitive one and we don’t need one.
I feel I’m so close to grasping it but my brain isn’t sharp enough today. Annoying. I’ll come back to it tomorrow.
A BOP deficit?
In practice, if the risk adjusted returns of the currency is overvalued, then the currency will depreciate.
‘Risk’ here, means a plethora of variables.
capital flight.
Arbitrage as such should not be the reason for a currency depreciation. for e.g. when we posit that forward rate converge to the spot rates over time and back by arbitrage argument it is actually because forward prices, if less than spot prices, would result in a increase in the demand for forwards and subsequently increase its price. (talking about long positions here)
Hence, in relation to interest rate parity, excess returns(which is wrongly stated here as arbitrage) should put downward pressure on the interest rates. (you keep investing more and more money in a bank at a given rate obviously it cant keep it up and has to lower the rates, also it now has a lot of reserves so it wants to lend again leading to lowered rates) why it should affect the exchange rate beats me.
mundell-flemming model makes perfect sense to me.
Any thoughts on this guys??