effect of interest rates on forex clarification

Higher real interest rates attract foreign capital and increase the demand for a currency thereby causing currency appreciation. However, interest rate parity indicates that higher interest rates cause depreciation. Does IRP assume that real rate is constant between countries and forex rates adjust because of inflation differentials? If so, how does this differ from the International Fisher Relation? Or does Fisher simply support the notion that real rates are constant across boarders and inflation is the only influence to currency movements.

i think if i may put it simply, higher real rates will cause the currency to appreciateā€¦but thats in the spot market. However going forward, we would expect the parity relationship to come in. and in an arbitrage free environment, the forward rate is expected to depreciateā€¦ i hope that helps abit

There are several things going on here: 1) Covered interest rate arb absolutely prices the forward currency rates in markets in which those are traded. If your job is to arbitrage currency, you could care less about the trade deficit, actions of the central bank, etc. All that matters is that the forward rate corresponds to the difference between two interest rates. 2) The forward rate is more or less unbiased for the expected future spot price - an effect that everyone tries to avoid in trading FX, but is tough to beat. 3) IRP is a static condition that relates two interest rates with each other and then prices the foreign currency. Two currencies could spend years and years with the same forward appreciation rate on their currencies and nothing would change except the exchange rate. The real rate of return for an investor would be the same keeping their money in either currency. 4) CHANGES in interest rates bring in all that stuff about increasing demand for newly higher yielding currencies. Obviously, the forward markets respond to changes in interest rate differenntials immediately but then there are these macroeconomic effects which may or may not cause changes in the currency. (BTW - Trading on these macroeconomic effects is really tough. The moral equivalent of trading on a stock that changes its payout ratio.)

Thanks JDV.