E(%ΔSd/f) = (rd − rf)…
Doesn’t higher domestic interest rate lead to higher demand for domestic currency => thus appreciation of domestic currency i.e. S (d/f) decreasing? The equation above suggests the opposite…
Could anyone please explain?
E(%ΔSd/f) = (rd − rf)…
US (domestic rates) = 10%
UK (foreign rates =) = 5%
E(%ΔSd/f) = (10% − 5%) = +5%
But equation is uncovered interest rate parity.
It is a theory that assumes different to what you are saying.
You will receive the same return in any current.
US (domestic) person can get.
US interest rates 10%
UK rates = 5%
E(%ΔSd/f) = (rd − rf)…
E(%ΔS USD/GBP) = 10% - 5% = 5%
GBP appreciates 5%
The change in FX compensate you for difference in interest rate.
Does uncovered interest rate parity hold in real life? No
Is what you say about spot rates more likely correct? Yes - especially short term.
But for L2 you need to know what covered and uncovered interest rate parity work and be able to say why they may be wrong, as you have.
Thank you!! Clear now.
From what you are saying, it does beg the question though: Is Interest rate parity flawed as a concept rather than thin on practicalities…(?)
It seems the explicit assumption is other things constant: i.e. if currency is expensive => trade will fall and so will the currency value. But there is no explanation of why demand shift in one direction would be greater than in the other.
Implicit assumption it seems is that something radical is going to happen in the long term, i.e. Central Bank will drop interest rates (‘run out of money’) or Start printing money, which would then trigger PPP and decrease currency value…(?)