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Interest Rates and Currency Appreciation

Hi

I’m a little confused now with the interaction of currency exchange rates and interest rates.

If I put my monetary policy hat on (and quite dashing it is, I might say) I get that if I raise interest rates, money comes flowing into the country / currency and that strengthens the exchange rate because more people want my currency so the “price” of that currency goes up.

However, with my forward premium/discount hat on (less dashing - more of a back-up for my Aunt’s wedding), the currency for which the interest rate is higher  is actually trading at a forward discount i.e. it is expected to depreciate vs. the other currency.

Any help would be highly appreciated.

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Theoretically, your first statement is correct. However, in reality (I know since I live in an emerging market), when you push up interest rates, it generally gives a signal that the economy is heating up and is maybe on the verge of a recession, so investors may not always pour in.

Therefore, what pans out in reality is your second statement.

Hope this helps!

You’re treating interest rate parity as if it were a force (or, at least, as if it were the only force) to influence exchange rates.

It isn’t.

The purpose of interest rate parity is to prevent arbitrage, not to try to predict future exchange rates.

Simplify the complicated side; don't complify the simplicated side.

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fireside wrote:

Hi

I’m a little confused now with the interaction of currency exchange rates and interest rates.

If I put my monetary policy hat on (and quite dashing it is, I might say) I get that if I raise interest rates, money comes flowing into the country / currency and that strengthens the exchange rate because more people want my currency so the “price” of that currency goes up.

However, with my forward premium/discount hat on (less dashing - more of a back-up for my Aunt’s wedding), the currency for which the interest rate is higher  is actually trading at a forward discount i.e. it is expected to depreciate vs. the other currency.

Any help would be highly appreciated.

Both of these are correct understanding. The issue is that the 2nd part assumed uncovered interest rate parity holds, while research has shown that it actually doesn’t. As a result, forward rates are biased estimators of future spot rates and should not be used to predict them. There’s a strategy called “trading the forward rate bias”, which monetizes this exact “property” (i.e. the currency traded at a discount doesn’t actually depreciate as much as predicted or even appreciates).