I have just come across the concept of interest rate parity in my studies and found it very interesting. The basic form being FORWARD = SPOT[(1+domestic interest rate)/(1+foreign interest rate)] To not follow this relationship leads to an arbitrage opportunity so it should hold most of the time…so I see this as way to make a call on using what is known about interest rates to make a prediciton on where currencies will head or vise versa.
I was thinking about the general assumption that when the Fed starts raising rates the dollar will get stronger. This makes sense because essentially it will be the opposite of QE and money supply will get smaller. HOWEVER, according to interest rate parity (lets just look at the USD/EUR situation) if we raise interest rates, the forward exchange rate should increase… that means a depreciation of the dollar??? yes?
so if there are no holes in my reasoning( if there are please fill them in because I am very curious about all this), If interest rate parity is being violated by the dollar getting stronger on a rate hike then I would want to borrow in euros and invest them in the US when rates get higher because it would be an arbitrage situation. However, if interest rate parity is expected to hold then time to short the dollar because it is about to depreciate.
I must be oversimplifying. comments?
***also note that the interest rate parity uses domestic/ foreign for the forward and spot rate AND that CFA notation is the opposite of Forex so an increase in the forward rate is the uqivalent to a depreciation of the domestic currency.