The International Fisher Effect says that any changes in the difference between 2 countries interest rates will be offset by changes in the exchange rate.
If the difference between county A’s interest rate and country B’s interest rate increases by 1%, for example country A raises its rate 1% or country B lowers its rate 1%, then the International Fisher Effect says that country A’s currency should depreciate 1% against country B’s currency to offset the change in rates. Sometimes the two terms, Interest Rate Parity and the International Fisher Effect are used interchangably.
Let’s look at a basic example to clarify what all this means:
The spot rate is the exchange rate between two currencies at that particular moment. In other words, right on the spot.
The forward rate is the exchange rate that is paid now to exchange two currencies at a later time. In other words, to lock in an exchange rate now for money to be exchanged on a future date.
Let’s say someone from the US wanted to invest some money into a foreign bond from country A.
First, they would convert their money from US dollars into Country A’s money.
Then they have two choices: They can either wait until the bond matures, collect their profit and then convert their money back into US dollars.
Or, at the time of purchasing the bond, they can also purchase a forward contract, which is a contract to lock in the exchange rate now for money to be exchanged at a later date.
If they choose to buy a forward contract and lock in the price now, Interest Rate Parity states that the difference in price between the spot rate, the exchange rate they get for converting the money today, and the forward rate, the exchange rate they have locked in for exchanging the money back to US dollars at a later date, should equal the difference in interest rates between the two countries.
In other words, the exchange rate they get for changing the money back at a later time will offset the amount of money they make in interest from the bond and they will break even. Otherwise, investors could borrow money from one country, lock in the rate to exchange the money back again, and profit from it without taking any risk.
If the investor chooses to not buy a forward contract, and instead chooses to just convert the money back to US dollars after the bond matures, the International Fisher Effect states that the exchange rate will have depreciated over this amount of time to offset the interest earned from the bond.
So if an investor borrows money from one country, coverts it into another countries currency, and then purchases a risk free investment in that country, such as a bond, Interest Rate Parity, and the International Fisher Effect state that the exchange rate will adjust so that profit made from the investment will be exactly offset by the cost of the loan.
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The model states that the currency from a country with a higher interest rate should appreciate against the currency from a country with a lower interest rate, because money will flow into the currency with the higher interest rate, and out of the currency with the lower interest rate, from investors seeking the higher yield
This is similar to the Asset Market Model, only this theory states that the higher interest rate will make not just the countries assets more attractive, but will make the currency itself more attractive as an investment, causing demand for the currency to increase.
The longer the difference in interest rates is expected to last should determine how much of an impact the interest rate has on the currency. If a large interest rate differential is expected to last a couple of years, it will have a much larger effect of the currency than if it is only expcected to last a few months.
The Real Interest Rate Differential Model is the fundamental basis of the carry trade. The carry trade is a fundamental trading strategy that involves selling a currency with a lower interest rate, and buying a currency with a higher interest rate. The theory is that the higher interest currency should appreciate against the lower interest rate currency, causing the investor to profit both from the change in exchange rates, as well as the difference in interest rates. There will be more on the carry trade in the strategy section.
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So that’s the Interest Rate Parity and Real Interest Rate Differential Models.As you can see, both of these economic theories offer equal, yet opposite opinions regarding how a currency will react to changes in interest rates. One theory states it will appreciate, and another states it will depreciate. So which is correct?
Actually, to some extent, they are both correct. Like with all economic theories, if one focuses on just the factors effecting the theory, it proves true. However, both of these theories have their problems including that they focus only on interest rates and financial assets, while totally ignoring trade flow.
Once one has an understanding of basic marco economics, an understanding of basic economic theories, an understanding of the major economic reports and data, and an understanding of the current economic situation of the countries they are trading currency from, then they have a good foundation for adding some fundamentals into their trading strategy. For instance, they might use fundamentals to develop a longer term bias as to market direction.
In other words, once they learn what moves the market, why it moves the market, how it moves the market, and where the market is fundamentally right now, it becomes much easier to figure out where the market is going to end up.
Music:
Danse Macabre – Low Strings Finale (Theme)
Home Base Grove
Impact Andante
Exotic Battle
Kevin MacLeod
incompetech.com
