Interest Rate Parity

IRP equation: So * [(1+dc)/(1+fc)] If your IRP equation is expressed in direct quotes (DC/FC), why does the foreign currency depreciate when foreign interest rate increases? I understand that the denominator rate is foreign rate which causes the decrease. However, intuitively it doesn’t make sense to me. Here is my rational: foreign rates increase -> demand for foreign currency increases -> foreign currency appreciates.

I’m trying to reach the answer of the same question whole day long :frowning: My logic is the same- higher risk free rate=higher demand=appreciation, but the formula says something else…

edit: ignore me, let me think a monite

IRP is a no arbitrage condition: The relationship can be seen when you follow the two methods an investor may take to convert foreign currency into domestic. Method A would be to invest the foreign currency locally at the foreign risk-free rate for a specific time period. The investor would then simultaneously enter into a forward rate agreement to convert the proceeds from the investment into U.S. dollars, using a forward exchange rate, at the end of the investing period. Method B would be to convert the foreign currency to U.S. dollars at the spot exchange rate, then invest the dollars for the same amount of time as in Method A, at the local (U.S.) risk-free rate. When no arbitrage opportunities exist, the cash flows from both options are equal. The no arbitrage condition says you will get equal results in methods A or B , because investors would quickly arb out any opportunities to do otherwise. hence the IRP equation will come back in line. Forward contracts on the foreign currency is the mechanism used to do this arb out.

So what you mean is that the currency is not appreciating but by getting higher the forward rate is compensating the depreciation, because of the lower risk free rate? Do I get it right? … I did the calculations and got the “arbitrage free” idea. Thanks a lot.

If the foreign rates are higher , everyone would flock there , make a lot more money by lending there and repatriate the earned interest back to the home country ( assuming stable rates ). If the exchange rates were stable , that would be a free-lunch as you could make more money abroad than by investing here. While this is not a bad ting , if too many people started doing it , the forward markets on the foreign currency would begin to discount the trade , and would hammer the foreign currency down , until everyone realizes it is not a free-lunch and domestic less-inflated dollars are about equal to foreign higher-inflated currency from an investment perspective. Thats when a temporary imbalance to parity would be restored : IRP

zazu11 Wrote: ------------------------------------------------------- > I’m trying to reach the answer of the same > question whole day long :frowning: > My logic is the same- higher risk free rate=higher > demand=appreciation, but the formula says > something else… Zazu and Achilles: Let’s keep this conceptual - I’m not going to cite formulae here. Zazu, you are right that if the REAL risk free rate went higher in one country relative to another, the currency would appreciate. However, when the question tells you the Country X’s interest rate is headed higher, IRP says that this is because this is because of country X’s currency is expected to depreciate. The IRP relationship holds because you’re not making any more real money. Yes, you’re making a higher NOMINAL interest rate [more green pieces of paper in your hand, say], but you’re not making a higher REAL rate [each piece of green paper in your hand is worth a little less]. If you can think of it this way, it makes all the calculations wayyyyy easier.

Thanks it’s clear now.

i was stuck with that too. got it now. thanks