Impact of Interest Rates on Foreign Exchange Rates

OK…as is obvious from the subject…Im no expert on Forex…heres my question which Im sure most of the people here will answer easily! Forward exchange rates are deteremined by the exchange rate differential between the domestic currency and the foreign currency. The no arbitrage forward price implies that the currency with the lower interest rate appreciates and the currency with the higher exchange rate depreciates. I get that. However, that in some way implies that a lower interest rate is better for the currency as it will lead it to appreciate. However, whenever interest rate cuts are announced, the spot rate for the currency always goes down and if interest rate increases are announced, the currency appreciates. The logic there is that if interest rates reduce, traders borrow more of that currency and if interest rates rise, traders invest more in that currency. Is it only me and have I got this completely wrong, or is there a dichotomy on the impact of interest rates on forward rates vs. spot rates? e.g. a higher interest rate leads to the spot rate appreciating bu the forward rate depreciating?

sorry…typo… in the second paragraph the currency with the higher INTEREST rate depreciates (instead of exchange rate)

This is not a stupid question… lots of smart people get weirded out by this seeming contradiction. It helps to break this down into short term and long term effects. In the short term, the marginally satisfied investor will sell the currency that isn’t yielding as much in order to grab the currency that yields more. This makes sense financially if you assume that the currency exchange rate will more or less stay constant. In fact, exchange rates don’t usually stay constant in the short term, because supply-demand adjustments lead to more buying into the higher exchange rate and selling of the lower. However, it is difficult to predict exactly how much the change in rates is likely to change the currency pair because there is lots more going on with currency demand than simply what the government is willing to pay to borrow some. The forward arbitrage effect is a longer term effect, and the reason why it works is that making or losing money on the arbitrage doesn’t actually depend at all on how the exchange rate evolves over time. Because you are using (in developed countries) risk free fixed income instruments, all the steps to guarantee money are taken at Time=0. It’s strange, but when you play with the math, you start to see it better. Because of this, there is another consequence which is that just because forward arbitrage rates are fixed by relative interest rates, they do not necessarily predict at Time=0 what the exchange rate will be when the future expires. That’s the part that’s counter-intuitive. Forward rates do not necessarily predict future exchange rates (they basically do if you have sufficiently free trade and liquidity to guarantee purchasing power parity, but how likely is THAT in the real world). Just as with the buying and selling of government securities, it turns out that there’s a lot more that determines currency exchange rates than the buying and selling of currency futures. If you have a decent model to predict future exchange rates, then you can use current futures prices to exploit that model. The challenge is that the rates are determined by a lot of non-economic forces, so there is lots of noise. Finally, the two approaches can be reconciled if you think about when the changes in exchange rates happen. If markets are perfectly efficient (bleh!) and the currency and futures prices change instantly to reflect new information like that, what’s going to happen is that there is an instant drop in one currency’s value as people reach for the higher yield. This NEW exchange rate is the spot rate that the futures price will be working off of, so if you assume that futures prices are unbiased predictors of future exchange rates, what’s going to happen is that the rate of relative appreciation will increase to compensate for the immediate drop in exchange rate prices. Of course the rate of return will be guaranteed for different lengths of time for different future expiration dates, so the actual drop in currency price will presumably be some kind of weighted average of demand for these futures. As you can see, there are a ton of assumptions that need to be made for the math to work, and these assumptions probably hold “on average,” but in currency work, there are lots of non-economic actors that are influencing the price, so that’s part of what makes it all fun. Personally, I just hate trying to keep track of which currency is in the numerator and denominator. Everything else is fun in currencies.

thanks bchadwick… that helps… Just an example to clarify… Assume the USD/AUD rate is 0.90 (i.e. 0.90 USD for 1 AUD) and interest rates in AUS are 7% and in the US are 3%…and everything is in equilibrium etc. The forward rate would have you believe that the USD is going to appreciate to lets call it 0.80 in a year (I know the number is incorrect…but it doesn’t matter for this example). If the AUS raises interest rates to 8%…are you saying the spot rate will rise to lets call it 0.92 and the forward will either appreciate less than the spot, stay constant or depreciate?

There are probably people who are better at FX than I am here, but this is what I see happening. 1. AUS rates go up from 7% to 8%; USD rates stay constant at 3%. Other things don’t matter; PPP roughly holds. 2. Demand for AUS goes up to capture the 8% and people sell USD to do it. This makes USD/AUD rise. (I sometimes reverse this by accident b/c of numerator/denominator tracking issues) 3. Covered interest arbitrage says that the currency with the lower interest rate is expected to appreciate over time; that’s the USD in this case. (in PPP terms you can think of it as assuming that there is going to be the same amount of “stuff” in the economy to buy, but that X months later, there’s going to be Y% more currency to buy it with - that does assume that the only source of additional currency is bond interest, which isn’t quite true) 4. The expected appreciation of USD from futures is now approximately 5% (= 8%-3%), instead of 4% (= 7%-3%). (so USD/AUD will go down about 5% in a year to reflect a stronger dollar) 5. Of course, you are now getting an extra 1% of appreciation off of a USD that has just lost some value. So the USD has gone down due to an unexpected change in rates, but now it should appreciate back up because of the greater interest rate differential. The intuition is really that if PPP holds (as it theoretically should), there should be 0% average return on currencies, so that if the currency goes down today, there is an effect that pushes it back up tomorrow. Now, there are plenty of reasons why PPP doesn’t really hold over the short term, and that’s probably how a lot of currency people make money. Basically the two main reasons AFAIK are that it takes time for prices to readjust (momentum) and the presence of non-economic actors who want the currency to be at specific places and will intervene to ensure it. 6. If PPP holds strongly, USD/AUS will presumably have lost about 1% right now, so that over time you get back 1% in appreciation. This isn’t strictly true because the currency just took a specific hit right now of some defined percentage, and if you can presumably hold an interest rate differential as long as you would like to grow it back to the original exchange rate, so the real % loss on USD taken at Time=0 is probably a weighted average of how far out people are going on their futures. Also the shape of the yield curve may change too, so that the rates applicable to different future expiration dates, depending on demand at different maturities. So it gets complicated here, but that’s more or less how I see it happening.

Great! Thanks for that…really helps!