higher interest rate -> depreciation of currency?

CFA Level II
#1

Is it a correct stmt?

I am confused by two conflicting concepts. INvestors chase interest rate. Higher interest rate will increase the demand for the currency and lead to appreciation.

But when you look at uncovered interest rate parity formula, higher interest rate will lower the the currency fx rate

E(S1) = S0 * [1 + i_dc] / [1 + i_fc]

What am I missing here?

#2

Any help here?

#3

Higher Real interest rates will lead to higher demand from inverstors and thus an appreciation of the currency. In the formula they use the nominal interest rate. http://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91309224

#4

Assume spot rate = $1/E1, 1 dollar = 1 Euro.

If interest rate in Europe is 10%, and interest rate in the U.S. is 5%, you may think that you should deposit your money in Europe and earn 10% instead of the poor 5% U.S. rate! However, covered interest rate parity says not so fast, because the forward rate is $1/E1 * 1.05/1.10 =$0.955/1E. So the Euro will weaken to the point where you end up making 5% return, no free lunch.

Inflation comes in from the uncovered interest rate parity, which says that the *expected* exchange rate a year later will be Today’s Spot * 1+Inf(U.S.)/Inf(Europe). That is, the reason interest rate in Europe is higher than in the U.S. is because Europe has a higher inflation rate, according to this view. That means the inflation differential is same as the interest rate differential, i.e., 1.05/1.10 is same as 1+Inf(U.S.)/Inf(Europe). This is only true if *real* interest rates are same between the two regions. Putting these two concepts together leads to the *forward* rate being the same as the *expected* spot rate (this is called the foreign exchange expectation relation).

So, if *real* interest rates are rising, that will attract capital and currency will appreciate, but if the higher interest rate is simply due to inflation differential, then it does not affect the currency.

#5

Awesome Dreary. Got it, so for an investor, chasing interest rate need to consider inflation. So my first stmt is not quite right.

For uncovered IRP, as Zanalyst mentioned, it’s nominal rate. But it is still true that when interest rate increase, exchange rate will decrease, not adjusting for inflation.

#6

Thanks.