CFAI Question: Interest Rate and Exchange Rate movement

2 countries A & B, currency x & y. If interest rate in A > interest rate in B, which relationship is true?

Answer: ccy x is expected to depreciate relative to ccy y and trade with a forward discount.

I thought if Interest rate is higher in A, that means there’s more demand for its currency thus it appreciates, no?

Can someone pls explain to me? The first scenario is due to nominal interest rates and the second is true if we are dealing with real interest rates. Do they mention what kind of rate in the question?

According to Interest Rate Parity, *real* interest rates must be the same across currencies. So, any differences in *nominal* interest rates must be due to expected appreciation or depreciation.

For instance, say EUR rates are 5% and USD rates are 2%. Does this mean we should only put money in EUR? No, according to interest rate parity, which says that EUR is expected to depreciate 3%. So, USD or EUR rates will end up with the same return in real terms.

In real life, interest rate parity does not always work, especially in the short term. In real life, high interest rates attract capital inflows, particularly in the short term. BRL is a good example of this happening in real life. However, if CFAI will want to test you on the concept of interest rate parity, so you should understand this, even if it is just a model.

It is due to the difference between nominal and real rates.

The CFA is so unclear on this.


Did you find out the answer in the end? If you do, please share with me. Thanks.


This is my take you guys can yell at me…

International Fisher - Ccy rates will adjust to difference in real IR - Long run philosophy

If more real IR, then the forward expectation is that CCY will fall as (Cap mkts will flood, cause infl and cause CCY Depr)

The Money Demand theory - IR increase leading to CCY appreciation and Bond prices depr

This to me, is more of a short-run as it attracts invesment

So imo they really do not contradict…

Reread ohai’s comment.

If parity holds, higher rates = higher expected inflation = currency expected to depreciate

higher REAL rates = higher demand for currency = currency expected to appreciate

International Fisher says Ccy rates adjust to real differences not inflationary differences…