Interest rate parity & media explanation

Hi, I am confused about effects of interest rate changes on exchange rates. As per the Interest Rate Parity theory, if interest rates of country A increase, with respect to its counterpart country B, the currency of A should devalue to remove arbitrage opportunities. However, I regularly read in the media, that a certain country’s currency devalued as a result of its decision to cut down its interest rates. For example the following excerpt talks about how the Canadian dollar appreciated as result of US cutting its interest rate. Could you please help me understand this? Thanks. When Canadian interest rates are markedly higher than those in the US, Canada becomes a more attractive destination for interest sensitive capital flows. This situation results in higher demand for short-term assets in Canadian dollar and thus places upward pressure on the dollar itself. When Canadian interest rates are lower than, or comparable to those in the US, the opposite holds true and the Canadian dollar typically weakens. (source:http://dsp-psd.pwgsc.gc.ca/Collection-R/LoPBdP/EB-e/prb0322-e.pdf)

Malhar, this has been discussed on this forum. To reiterate the point - there is no conflict. Iterest parity is arbitrage free condition and it will hold (given liquidity and transaction costs) for a given currency pair. If real interest rate is increasing (in comparison to the other country), country provides attractive return opportunities, economy will grow and capital inflow will accelerate which will cause currency to appreciate. Again, this is not an arbitrage free condition and significant amount of risk is involved when making such a bet.

You can also think about it in terms of PPP, if PPP predicts exchange rates correctly and real rate is higher in country A then in country B and inflation is the same, then if you convert at spot and invest in A and convert back in the future, you will get higher return then in country B.

comp_sci_kid Wrote: ------------------------------------------------------- > Malhar, this has been discussed on this forum. > > To reiterate the point - there is no conflict. > I think I stopped answering this question like 6 months ago. Why doesn’t CFAI address this since it seems to confuse everyone? > > Iterest parity is arbitrage free condition and it > will hold (given liquidity and transaction costs) > for a given currency pair. > > If real interest rate is increasing (in comparison > to the other country), country provides attractive > return opportunities, economy will grow and > capital inflow will accelerate which will cause > currency to appreciate. Again, this is not an > arbitrage free condition and significant amount of > risk is involved when making such a bet.