disptra Wrote: ------------------------------------------------------- > > First off, the US dollar appreciating forever > is > > not necessarily a good thing. > > > > Second, there’s arbitrage and there’s economics. > > > In the forwards markets, arbitrage wins every > > time. So if the US interest rates dropped to 0 > > (it’s something like the repo rate that needs > to > > drop to 0, btw) and the pound was yielding 6%, > the > > pound would start trading at a 6% annual > discount > > in the forward market. If not, there is an > > arbitrage to make it so. So now your best > guess > > for the spot rate a year from now is that the > > dollar will appreciate by 6% because while > forward > > rates are not great predictors of future spot > > rates, there is not any particular evidence > that > > they are biased. > > > > If US interest rates dropped to 0 because there > > was no demand for US dollars, then the dollar > > probably wouldn’t appreciate by 6%. On the > other > > hand interest rates dropping is supposed to > take > > care of the demand part by itself so as the > price > > drops the economy would pick up and demand > would > > start again. But of course, sometimes it takes > > years to correct and then you have something > like > > the yen carry trade that worked for years. > > Thanks! Let me try to understand this. > For example: > In the beginning U.S. interest is 5 % and British > interest rate is also 5%. Now U.S. drop interest > rate to 1%, investor will sell U.S. dollar right > away, so in short term. U.S. dollar will > depreciate. > No if the US risk-free rates drop the forward market will almost instantly pick it up. If you can lock in a rate in the forward market and pick up a risk-free profit, all the machines will do it right away. This is “covered interest arbitrage”. > > But now interest rate parity will start to kick > in. > So in the long term, U.S. dollar should start > to appreciate if both countries hold its interest > rates. In the very short term, covered interest arbitrage is by far the biggest effect. In the long term, it’s about macroeconomics and the billion things that control currency movement. There is no question that interest rate parity is exerting a pull though. > This question asked about effect after the initial > interest rate drop. So the answer is to > appreciate. > > Is this correct?
Joey. Using the same example. I agree that forward rate will reflect interest change right away. But it will only appreciate dollar gradually. Initially, dollar (spot) has depreciated due to lower interest rate. Considering one year forward rate, it will take a year to realize the full effect of it on the spot rate. So hold everything else constant, dollar will initially depreciate(do you agree this?) and start to appreciate gradually due to interest parity. It may even offset initial drop in the long term? This seems to be only explanation I can come up with.
BTW, I have a lot of trouble with this topic, too. But, I am starting to grasp the concepts by plugging numbers into the equations. It seems to me that if the US rate is 4% and the London risk-free rate is 7%, then the US dollar has to appreciate in order to “catch up” to London’s higher interest rate…or else, arbitrage opportunities exist which will go away with time because of the market. It will appreciate, so the $, which could be trading at $0.96/pound, would trade at a forward rate of, let’s say 0.94/pound. It would take less US to buy 1 pound in the future to offset the interest rate discrepency. Am I nuts, or is this somewhat of a correct understanding?
disptra Wrote: ------------------------------------------------------- > Joey. > > Using the same example. > I agree that forward rate will reflect interest > change right away. But it will only appreciate > dollar gradually. > Initially, dollar (spot) has depreciated due to > lower interest rate. Considering one year > forward rate, it will take a year to realize the > full effect of it on the spot rate. > So hold everything else constant, dollar will > initially depreciate(do you agree this?) and start > to appreciate gradually due to interest parity. > It may even offset initial drop in the long term? > This seems to be only explanation I can come up > with. I guess the question is something like is there a negative correlation between spot rate and short-term interest rates. There probably is, but it’s not a very strong effect. In particular, currency is a lot more volatile than any short-term interest rate so only a small part of its variability could be explained by interest rates.