I know this is a big area for the L2’ers but can someone refresh my memory (I don’t work with exchange relations often). According to parity rules, the country with the higher risk free rate will have its currency depreciate to eliminate arbitrage opportunties F=dc/fc * (1 + RFRdc / RFRfc) But isn’t this contrary to the concept of higher interest rates means higher demand for the currency and a capital inflow which causes it to appreciate?
dieselbp67 Wrote: ------------------------------------------------------- > I know this is a big area for the L2’ers but can > someone refresh my memory (I don’t work with > exchange relations often). > > According to parity rules, the country with the > higher risk free rate will have its currency > depreciate to eliminate arbitrage opportunties > F=dc/fc * (1 + RFRdc / RFRfc) > > But isn’t this contrary to the concept of higher > interest rates means higher demand for the > currency and a capital inflow which causes it to > appreciate? This is, from what I remember, based entirely on the theory of PPP. However, as we know, PPP doesn’t hold in the short run, mainly due to transportation costs and legal and regulatory issues. The idea is, that a higher rate is a response to inflation, which is thus eroding the value of the currrency. Of course, in the real world this doesn’t often hold, but rather is the inverse. The whole idea is really quite stupid, and likely shouldn’t be tested by CFAI. But hey, if your good at proprtions and ratios, it’s very very easy points on the exam.
I think the answer is that a CHANGE in interest rates will cause money to flow in to take advantage of the increased interest rate. and strengthen the currency. After a short term change, the currency will stabilize at a new value, because arbitrageurs will be selling the currency sufficiently to keep the price in line with covered interest arbitrage values. Now INSIDE that currency zone, the change in interest rates will affect the distribution of money going to various assets, so there will still be plenty of activity going on as a result of an interest rate change.
any nominal interest rate has 2 components. Real interest rate component and Inflation component Rate1 = R1+I1 Rate2 = R2+I2 Rate1 > Rate2 I1 = I2 R1 > R2 Currency starts to flow to the country where Real interest rate is higher, causing C1 to appreciate, not that that forward rate will be lower given covered interest rate parity, so there will be significant currency risk premium. Eventually, high growth is not sustainable without higher inflation. Higher inflation in the long run will cause currency to depreciate and investors will retract as investment opportunity yields will be offset by currency depreciation That is how understand it