Pg. 298 (Book 5), Reading 40. The reading mentions that if the currency of a country with an exchange rate target devaluates, the country will raise the interest rates thereby the bond prices will reduce. Thus, when the currency devaluates the bond prices will drop and therfore the covariance between the two is positive. My question is that when the currency devaluates and the country raises the interest rates in response to it, will not the raising of interest rates lead to raising the exchange rate. So the reference event is raising the interest rates and once that happens the bond prices will drop and the currency exchange rate will start increasing. Should not the covariance be negative?
Any thoughts? 
i’m bumping this up. i too had the same question. how to reconcile interest rate parity which predicts a depreciation in the currency w. the higher interest rates, with the idea in reading 40 that a country w. an exchange rate target will raise rates when its currency has depreciated? if you raise your rates, won’t all the market players engage in arbirtrage by selling your currency forward, driving down the forward rates?
If a country raises rates, it doesn’t necessarily mean that the currency will rise. Maybe real rates are lower than before or maybe other countries are rising as well, increasing the difference btw interest rates (Idc - Ifc). IRP is based on two country and two currencies. If a country is raising rates, what is the other country doing?
Hmm. Lets assume that the real interest is unchanged (which it generally is unchanged) and let’s further assume that the other interest rate is unchanged. all else being equal, in the presence of liquid currencies and active futures market, shouldn’t an increase in a country’s interest rates lead to currency DEPRECIATION? reading 40 suggests otherwise, namely that the country w an FX rate target will RAISE rates when its currency depreciates.
zoya, did you pass L2, this is covered extensively there.
i did pass level 2. Aside from that, do you have an answer to my question?
Short Term fluctuations in rates can have different effects. If the government is raising short term rates to invite foreign capital , its currency can begin to rise at the same time because of investor sentiment supporting the currency. Longer term though the country can face negative growth because borrowing costs are higher , so the government may lower short term rates eventually
thanks, janakisri i’m having a bit of a tough time picturing what the government is thinking when they do this. so let’s say i’m the central bank of Lalaland. We have a target FX rate of 1 lala to 1 dollar. Lately, lala is trading at 1.25 per 1 dollar. So, if i raise the local interest rates, dollar investors will pour in, sure, driving up spot prices for the lala. But, won’t those same investors start to buy forward contracts to convert back into USD? as more investors do this, the forward prices of dollars will begin to increase, value of lala will decrease. basically, IRP seems to contradict the idea that central bank will increase rates to counteract depreciating local currency. i feel like im missing something profound, not quite sure what tho.