Hey, I’ve a quick question regarding interest rates and exchange rates. I was reading through SS9 in schweser and in the section where they discuss whether a manager should hedge an FX rate or not they mention that a currency that has a lower domestic interest rate will appreciate in value according to hedged interest rate parity. However, I remember from reading 23 using the relative economic strength approach that a country with a high domestic interest rate can expect to have it’s currency rise in value due to investors buying the currensy to invest there and take advantage of the higher interest rate. (This is assuming that investors don’t see the high interest rate as being high enough to slow the economy). Am I missing an important point here? Thanks,
I believe that reading 23 is referring to short-term relative mispricing, while the interest rate parity is referring to long-term economic corrections towards equilibrium. Does that make sense?
A currency that has a lower domestic rate of interest is expected to appreciate in value relative to a higher yielding currency and forwards and futures contracts (if traded) must reflect that or there is simple covered interest arbitrage. There is never a “will appreciate” because FX rates are random. However, given a couple of short-term interest rates and the current rate, I can tell you the forward rate of the same tenor with small error. Further, that rate is arguably close to unbiased (if you believe not you should be trading those contracts). If a country raises its interest rate, then the forward contracts adjust immediately. If the rate increase causes more demand for the currency (which is nothing like a sure thing) then perhaps the currency will appreciate in value. The forward contracts are priced based on an arbitrage relationship and the idea that a currency appreciates in value when it’s interest rate rises is based on some questionable economics probabilistic relationship. Those two just don’t have equal standing.
Hi Joey, Not sure if that answers the question. How do you explain the discrepency in the notes? i still think that reading 23 is talking about short-term mispricing that can lead to arbitrage opportunities. Interest rate parity, on the other hand, assumes an arbitrage-free environment that would probably arrise in the long-run
I don’t know what the readings say because I don’t have them and I’m not sure what you mean by arbitrage (you should see the stuff that I’ve seen called FX arbitrage). There are two concepts (or even three): 1) Covered Interest Rate Parity - The thing that makes the lower yielding currency trade at a premium in the forward markets. This is for sure and for certain arbitrage related. 2) Uncovered Interest Rate Parity - A pretty robust effect that does not rely on traded securities but something like efficient markets. There’s a semantic discussion about whether this is arbitrage related. 3) Relative Economic Strength - People demand the currency more when the interest rates rise so the currency appreciates in value. None of those contradict each other; they all just dance together in pricing currency.
i guess the question should be rephrased for you since you dont have the notes. why does interest rate parity assume that a curency will trade at a forward if that country
s yields are lower than another countrys, while economic theory tells us that a currency will trade at a discount in the same situation?
Country A has an interest rate of 6% and country B has an interest rate of 3%. The currencies are actively traded in the Interbank market. The current exchange rate is 2 A-Thalers per 1 B-Thaler. I can enter a forward contract to exchange B for A in 1 year and the forward rate is completely determined by the 3 numbers above (you should be able to calculate it). The forward market says that B will appreciate relative to A. It absolutely must say that or I can make an absolutely riskless profit. If there aren’t forward contracts or other derivatives traded the relationship is somewhat weaker but still exists. In this case, uncovered interest rate parity is like purchasing power parity except that money is very transportable so it is much more likely to work quickly. Of course, now you can trade forward contracts in the trillions of dollars on most countries you can locate on a map so this is almost academic. So now there is the question of what actually happens. The forward markets aren’t “assuming” anything - they are just kept at the no-arbitrage price by machines that make it so in microseconds. But the currency moves and there are covariates for the currency moving. Trying to predict the expected spot price better than the forward price is a wildly difficult game though - currency markets trade more volume every day than the entire capitalization of the NYSE - and if you could predict currency movements better than the no-arbitrage price of the forward contract you could make arbitrarily much money (leaving risk aside here for a second). So now “economic theory” predicts that a country that raises its interest rates will have an influx of capital to take advantage of higher bond yields. That almost certainly happens for some kinds of interest rate increases. But take it to an extreme - in 1986 Mexican Cetes rates went to 125% because putting your money in peso meant you were taking on huge devaluation risk (and as it happened you would have gotten creamed). The forward prices absolutely said that the peso was going to be devalued because they were just priced according to some simple formula (well, not really, but never let the truth get in the way of a good story). There is this huge question in the economic theory of why the interest rates went up and was it the right thing. Some asnwers to those lead to some probabilistic conclusion that the currency should appreciate and some don’t. As a main effect it is 10,000 times weaker than the no-arbitrage pricing of forward contracts.
Joey, that is exactly how i understand it
JoeyDVivre Wrote: ------------------------------------------------------- > So now “economic theory” predicts that a country > that raises its interest rates will have an influx > of capital to take advantage of higher bond > yields. That almost certainly happens for some > kinds of interest rate increases. But take it to > an extreme - in 1986 Mexican Cetes rates went to > 125% because putting your money in peso meant you > were taking on huge devaluation risk (and as it > happened you would have gotten creamed). The > forward prices absolutely said that the peso was > going to be devalued because they were just priced > according to some simple formula (well, not > really, but never let the truth get in the way of > a good story). Is it a question of ‘real’ interest rates? If rates in country X increase, but at the same time expected inflation increases relative to other countries, then wouldn’t you expect not to have an influx of capital and a strengthening of the currency?
This is simple Finance 101 stuff. There should not be any arbitrage opportunity, so if the interest rate in country A is expected to increase, then currency of country A is expected to depreciate.
Must have missed that section. That’s not it. If the interest rate in A is higher than B, its currency is expected to depreciate. This is not about the change in interest rate; it’s about the differential.
jbaldyga Wrote: -------------------------------------------------------> > Is it a question of ‘real’ interest rates? If > rates in country X increase, but at the same time > expected inflation increases relative to other > countries, then wouldn’t you expect not to have an > influx of capital and a strengthening of the > currency? Sure - among other things, expected inflation from whatever reason can enter into the equation.