Page 71 of schweser says when interest rates in Mexico are higher (25%) as opposed to in US (5%), then an US Investor can take out a loan in US dollars,convert them in to Pesos and invest in mexico to get 25% return. But at the end of the year even if he has made 25% more in pesos but (if Interest rate parity holds) he will be able to exchange these pesos for only 5% more dollars than he started with. The Peso must deperciate. My question is why would the Peso depreciate? Common sense says that the peso should appreciate and the dollar vice versa as capital moves to take advantage of the Interest rates differential. Havent we seen the dollar depreciate everytime the fed cuts rate? Could someone please clarify this for me. Thanks in advance
because you are starting with the presumtion that interest parity holds. interest parity tells us that investors will get the same return on deposits once the exchange rate is accounted for. if the fed cuts interest rates then 2 things happen in my opinion 1 expected inflation is bigger which decreases demand for usd 2. some capital flees to countries that offer a higher interest rate, increasing supply of usd and increasing demand for foreign currency. in you situation if interest parity wouldn’t hold then people would borrow usd, exchange for pesos and benefit of the higher interest rate
Interest rate parity relation or covered interest rate parity relation is an arbitrage relation, therefore it has to hold other wise investors would be able to make arbitrage profits. Another important point is interest rate parity relation is for forward rates and not for expected spot rates in future. Therefore this relation doesn’t imply that the expected future spot rates will depreciate unless we assume that the international expectation relation holds. In reality international expectation relation never holds.
If its a true arbitrage scenario, like Kabhii mentioned its the forward rates that lock in the profit. I’ve asked myself the same question with regards to the flow of capital. I think the important factor that was missed above is the flow of capital will follow real interest rate differentials. In the states you have rising inflation and lower interest rates, not sure but I think you guys have a negative real interest rate?? I’ve been wondering why the South African Rand (my currency) isn’t strengthening against the dollar considering how high our current prime rate is. Real interest rates are at ±5.00%. Behavioural finance??
why doesnt anyone speak about the fact that the US dollar has the ‘advantage’ of being the ‘reserve’ currency of the world?. didnt some US bureaucrat once famously say “The dollar is our currency, but your problem.”
> I’ve been wondering why the South African Rand (my > currency) isn’t strengthening against the dollar > considering how high our current prime rate is. > Real interest rates are at ±5.00%. > > Behavioural finance?? Country risk? Investors weigh up the political and economic conditions as well as the real return - risk vs reward. Plus, as the readings point out interest rate parity re: expected future spot rates is a theory that has economic justification, but evidence suggests it still has limited explanatory power.
Dsylexic Wrote: ------------------------------------------------------- > why doesnt anyone speak about the fact that the US > dollar has the ‘advantage’ of being the ‘reserve’ > currency of the world?. Isn’t there a shift (or hint of a shift) towards the Euro as the “reserve currency of the world”? British Pound -> USD -> Euro?
My understanding on that question is that. If the REAL rates are higher, then the currently would appreciate. In that example, I would think REAL rate are assumed to be the same across borders and the fact that Mexico as such a higher nominal rate, is due to the fact that they have higher inflation, which will cause depreciation. At least thats how I see it.
This topic is related to the yen carry trade that has been the most profitable trade over the last 5 years. Borrow yen at nearly 0 interest rates and invest in EM, Commodities and other higher yielding assets (like NZD interest rates)… This trade has been extremely profitable as the yen hasn’t appreciated. People are now saying that the new trade will be the dollar carry trade as our rates are creeping towards zero. In practice IRP does not seem to hold but investor will need to take heavy currency risk if they try and generate arbitrage using carry trades.