This confused me for some time until I created a simple notecard, and it goes a little something like this… Interest Rate Parity – The forward premium/discount simply is the interest rate differential. The country with the lower risk free rate will experience a currency appreciation and vice versa. Purchasing Power Parity – The expected spot rate (NOT FORWARD) simply is the inflation differential. The country with the lower inflation will experience currency appreciation and vice versa. (this is relative PPP) International Fischer Relation – IRP and (relative) PPP combined. The inflation differential equals the interest rate differential. What really important thing does this imply? REAL RATES ARE CONSTANT. *Remember: nominal rates equal real plus inflation. Uncovered Interest Rate Parity – PPP and Fischer are combined to state that the expected spot price is explained by the interest rate differential (don’t confuse this with interest rate parity alone). This is “uncovered” because it’s unhedged, there is no forward contract here. Covered uses a forward contract to hedge the ‘bet’. Foreign exchange expectation relation – forward premium/discount equals expected exchange rate movement, or expected currency appreciation/depreciation. ________________________________________ Notes: *Covered Interest Arbitrage simply is like uncovered IRP, but uses a forward contract. Simply borrow DC at RF and exchange to FC. Lend the FC at its own RF, and use a forward to repatriate the currency at expiry. 1. Flow market approach - high economic activity and low unemployment lead to depreciated currency, and higher rates b/c of increased inflation. 2. Asset market approach - high economic activity and low unemployment leads to increased foreign direct investment b/c of high rates used to fight inflation, which leads to currency appreciation. 3. Real Exchange Rate = Nominal x (Price Levels foreign currency/ Price Levels domestic currency)
Nice summary, thanks
Thanks, this will come in handy.
I don’t get something why the country with the lower risk free rate experiences a currency appreciation and vice versa. Isn’t the logic that you should buy currency with higher risk free rates and sell currencies with lower interest free rate? So the currency with the higher rate should appreciate? What do I miss? Please help me with the logic.
Buying and selling is a way to arb an opportunity. If all everyone was doing was buy the appreciating currency and sell the depreciating currency , very soon opportunity would disappear as the trade gets discounted in the forward markets ( as one gets overbought and one gets oversold ) Parity would be restored quickly at new exchange rates ( spot & Fx )
Nominal rates should equal (1+real)(1+inflation) From taking BSAS there was a question that said APPROXIMATELY for linear approximation and a question that said EXACTLY. In both examples both answers were given. Watch the language come exam day.
zazu11: the logic is the other way around, you buy (borrow) the lower rate ccy and sell (lend) the higher rate ccy. So, if i went to a bank and borrowed $100 at 5% and then lent it in Euros at 6% and the USD/EUR rate was 1.00, i would borrow as many $$$ as i could to take advantage of this trade, the increased demand for $$$ would lead to appreciation.
Like zazu11, I am confused about the relationship. The flipside to ro424’s argument is that I would invest in the currency with higher interest rate returns. Hence expansionary fiscal policy is expected to raise currency appreciation by increasing interest rates. I think the key is differentiating between real rates and nominal rates. Parity relations are for nominal rates and assume real rates are constant. So for two currency which differ in nominal rates, it implies a difference in inflation rates. I can then tie interest rate parity to international Fischer effect. What would REAL interest rate parity look like then? Please correct me if I am wrong with my logic.
The closet thing is the inflation differential, for example… lets assume country A is the domestic currency and country B is the foreign currency lets assume the Spot rate for amount of currency A to buy one unit of currency B is 1.2/1…aka 1:1.2, aka A/B, aka B:A. If inflation is 4% in country A and 3% in country B we would expect the new spot rate to be 1.2 (1.04/1.03)=1.21165 Expected Spot Rate = Current Spot Rate [1 + Inflation in domestic currency)/(1 + Inflation in foreign currency)] This makes logical sense as inflation is higher in country A and the currency depreciates relative to currency B. In other other words it now takes more units of currency A to buy one unit of currency B.