Why does the country with the higher short-term rate have higher currency price appreciation expected? Doesn’t interest rate parity suggest that the country with the higher-short term rate should depreciate because real interest rates are equal?
I know this question is getting at drivers of currency price changes: PPP, Economic Strength, Capital Flows, and Savings-Investment… But it seems that the higher short-term rate augurs for a covered interest parity assessment.
schweser puts this like this:
investors would borrow from country with lower short term rate in local currency and sell the currency for another currency whose country offers high short term interest rate and invest the proceed in that country.
This action puts further downward pressure of currency (low interest) and causing it to depretiate.
That is helpful. So looks like covered interest parity and capital flows conflict.
but it could be looked like this also - higher borrowing from country with lower short term rate ==> Higher demand but at the same time selling the same currency ==> Downward pressure
So we have offsetting forces here. Any idea which one of them takes superiority?
That 's why we call it economics other than mathematics…
example: They say equities investment has good hedging for inflation. however, when inflation high, interest rate will increase and stock market go down…
inflation is a longer term effect . It takes a while for investors to realize that high interest rates could lead to hyperinflation, eroding asset values significantly, and they will withdraw funds in a hurry when they realize this. Until then it is boom time.
real interest rates could be higher in a growing economy that is trying to sustain its growth through incentives