Why are high nominal interest rates accompanied by local currency depreciation?

CFA Level II
#1

When higher real interest rates = currency appreciation? I assume it’s b/c you have to assume inflation is higher?

#2

According to UIP, expected S1/S0=1+r(fc)/1+r(dc), S denotes FC/DC. If r(fc)>r(dc), then S1>S0, FC depreciate, and DC appreciate. Does this answer the question?

#3

I see it in the formula, but am having a hard time grasping it conceptually.

#4

higher real rates => more attractive investment opportunities => flows of capital into the country => appreciating currency

#5

say if you have 2 idential assets ( same maturity, liquidity, risk…etc), one foreign, one domestic. As a risk neutral investor, you can choose to invest in either asset. If i > i* for instance, why would an investor invest in i* which pay a lower interest? the only possible reason is foreign currency depreciates. So after you convert your higher paid interest from foreign country, you get about the same amount worth in domestic currency. UIP is an arbitrage free equilibrium condition.

#6

there are 3 factors that cause a currency to appreciate/ depreciate: 1. Income level increase in income level ->increase in demand for Imported goods-> increase in demand for foreign currency-> depreciation of domestic currency 2. Inflation: increase in inflation ->domestic goods being costlier than imported goods->increase in demand for imported goods->depreciation of domestic currency 3. REAL interest rates: increase in real interest rates-> capital inflows-> increase in demand for Domestic currency for investments -> appreciation Nominal interest rates= real rates+ inflation so what causes the nominal rates to rise should be considered here i guess ( real rates or inflation?) hope this helps

#7

ng30 Wrote: ------------------------------------------------------- > When higher real interest rates = currency > appreciation? I assume it’s b/c you have to > assume inflation is higher? I’ve been using this assumption.

#8

yes…i guess… basically if you are comparing 2 currencies and their interest rates. U assume that the purchasing Power parity holds- that is: the real interest rates are equal in both countries. Hence if there is a difference in nominal rates, it can be only attributed to difference in inflation

#9

thanks guys