Covered interest rate parity ? (Higher interest rate; depreciation?

CFA Level II Economics
#1

Accorind to the covered interest parity:

Forward (f/d)= Spot (f(d) * [(1+ r(f)) / (1+r(d))].

So a higer interest rate in the foreign economy will depreciate its currecy.

I found the following on an aritcle about the factor that influence the exchange rate.

Imagine for the following that USA would be the foreign currency and the EUR the domestic currency:

“If USA interest rates rise relative to elsewhere, it will become more attractive to deposit money in the USA. You will get a better rate of return from saving in USA banks, Therefore demand for the USDollar will rise. Higher interest rates cause an appreciation.”

I completely agree with that logic, higher interest rate in an economy will attract foreign investor that would demand that currency and leading to an appreciation of it.

#2

There are (at least) two effects that interest rates have on exchange rates:

  • Interest rate parity: the currency with the higher interest rate depreciates vis-à-vis the currency with the lower interest rate.
  • Demand: the currency with the higher interest rate will have higher demand, causing it to appreciate vis-à-vis the currency with the lower interest rate.

Which currency ultimately appreciates and which ultimately depreciates will depend on the magnitude of these competing effects.

1 Like
#3

OK, understood it. I was just focusing on the demand effect.

Thanks again!

Much appreciated!

#4

My pleasure.

#5

just another fantastic explain of an otherwise complex topic. Many thanks
S2k Magician explanations are my flash card entries :slight_smile:
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