one of the factors that cause a nation’s currency to appreciate/depreciate : differences in real interest rates the arg is : if real rate is high in one nation -> capital will flow into that nation -> increase demand for its currency -> its currency will appreciate relative to other nations’ with lower real rate BUT according to interest rate parity -> if a nation’s interest rate is high relative to another -> then the expected exchange rate must fall for for IRP to hold to me, one is saying the contrary of the other. i know both must be true, since they are in the BOOK! but it beats me. i dunno what i’m missing to reconcile these two. help, any economics buff out there? i know it might not be a crucial cfa question to ask at this time, i just wanna get the intuition behind it.
the 1st thing you mentioned is with regard to REAL interest rates. The second one is nominal rates.
The first one you are talking about is Expected Future Spot Rate. The second one (IRP) is estimating Forward Rate and not Expected Exchange Rate in future. Forward Rate and Expected Future Spot Rate are two different things. Further, Forward Rate is decided at time t0, where as Expected Future Spot Rate is for time t. Hope it clarifies a bit.
thanks. got it. i also found this answer which gives more intuition http://www.analystforum.com/phorums/read.php?12,1141444 quoting from there “If the foreign rates are higher , everyone would flock there , make a lot more money by lending there and repatriate the earned interest back to the home country ( assuming stable rates ). If the exchange rates were stable , that would be a free-lunch as you could make more money abroad than by investing here. While this is not a bad ting , if too many people started doing it , the forward markets on the foreign currency would begin to discount the trade , and would hammer the foreign currency down , until everyone realizes it is not a free-lunch and domestic less-inflated dollars are about equal to foreign higher-inflated currency from an investment perspective. Thats when a temporary imbalance to parity would be restored : IRP”