why in the interest rate parity part, a higher interest rate of domestic country will result in the lower currency forward rate hinting depreciation of the domestic country. But the text also says a drop in the real interest rate in the foreign country leads to depreciatio of foreign currency? Do they conflict?
Interest rate parity is important for the balane in exchange rates. If the higher interest rate currency didn’t depreciate over time, this would create arbitrage. Therefore, this parity has to hold. Now, drop in real interest rate also isn’t favorable to the currency investors because their return goes down with the real interest rate. Therefore, the demand for that currency drops and hence the depreciation of the currency. In short, higher interest rate - currency depreciation. Drop in real interest rate - currency depreciation. as you can see that these two things aren’t necessarily in conflict. An emerging market currency (e.g. indian rupee) generally has higher interest rate. so in long run, it should depreciate. However, everytime inflation readings come out higher or government decides to lower the interest rate, you can expect to see the currency depreciate. I guess, what’s confusing sometimes with these types of textbook quotation is that they are written as “if all else equal…”. In reality, there are several forces acting in the currency market, and any other market for that matter. Hope it helps.
Thank you for your kind reply, but one thing still confused higher interest rate result in depreciation in order to prevent arbitrage can be explained by the interest rate parity equation, however, if we put drop in real interest rate in the interest rate parity equation, i found the currency should appreciate, confused
One of things to understand here, i think, is short term vs long term; expectation vs reality. Interest rate parity holds, but only in long run. Forward rates would reflect the parity, but over time there are several other factors in the market. As real interest rates drop, investors typically sell off the currency and therefore the demand of the currency drops and hence short term depreciation. This too is when all else is equal. Other factors could be political stability, potential growth, foreign, trade policies…etc.
Hello smark, I found out that CFA text gives 2 version of Interest Rate Parity formula. In Reading 54, exhibit 9, the interest rates used are the annual interest, where the (1+ra) or (1+rb) are to the power of (T-t). BUT in Reading 17, Example 6, the interest rates used are the “actual interest rates” which are obtained by multiplying the annual interest rates by the factor of time i.e. multiply by 3/12 if the contract is 3 months. Pls enlighten me on this. Thanks.