Relative strength or IRP, which one to follow:
This is really confusing me, IRP says the CCY with higher interest rate will depreciate where as relative strength says CCY with higher interest rate will appreciate.
Which one to follow? Any help?
what is CCY
currency can go up when the economy is strong and capital flows inwards are high . This happens when investors bet on continued strength and growth , inspite of low yields.
However if rates are high because of Central Bank intervention ( i.e. tightening due to high inflation ) or preceived weakness in the economy ( large risk premiums ) , then currency would depreciate to indicate lack of investor sentiment .
So it depends on the particular argument used in the analysis
WOuld it be correct to say that IRP is based on nominal rates (assumption being real rates should be equal) whereas relative strength is based on real rates? (I know, thin gruel, but trying to justify.)
C urren CY.
Just a general ccy as to how currencies work, Thanks Janakisri your point makes it clear now
Relative Strength: real risk-free rates between countries deviate (or country with higher nominal interest rate temporarily doesn’t not experience currency depreciation - think China) => capital flows to the country with higher real risk-free rate (or higher nominal interest rate and short-term-stable exchange rate) to capitalize on the arbitrage opportunity => currency of the country with higher rates appreciates in the short run.
IRP doesn’t always hold in the real world (some may argue it cannot possibly hold since there is no such thing as a risk-less asset or risk-free rate). Relative strength method attempts to show where IRP can fail.
Another point of view :
CCY appreciation or depreciation depend on the demand of the ccy.
As an analogy consider countries as corporates, where Relative strength of country is considered as growth of corporate or rise in equity and Interest rate available in country as interest rate available on corporate bond.
Now compare two corportes :
Company A : Growth rate (growth in equity) = 15% , Interest rate on bond = 10% , Good credit quality
Company B : Growth rate (growth in equity) = 10% , Interest rate on bond = 12% , Low credit quality
where would you like to put your money ? Relative strength (Growth )tell to invest in Comapny A ,while IRP tell to invest in B. Here Relative strenght wins as it is offering me higher return on my investment. So the Company A will be in demand, and this demand is further boosted by its good credit quality.
Now back to level of country. When a countries’ assets are in demand people have to buy its ccy to invest in the country, and when demand of ccy rises it value rises 