Currency exchange rate: doubts on CIRP, doesn't make sense

CFA Level II Economics
#1

Dear all,

first time write in the forum. I need some clarification on CIRP.

in the curriculum it is said that the currency with higher nominal interest rate will depreciate against the currency with lower interest rate. But seems to me this doesn’t make sense. Let’s make a “almost real simulation”.

USD/EUR 1.08

interest rate in Euro 0%

interest rate in U.S. 0.5%

so based on Cfa books, USD should depreciate against euro. But in reality as we learn from daily experience for example the recent fed raised interest rate, the dollar appreciate. So to me the logic should be the currency with higher interest rate should appreciate and not depreciate against the Lowe interest rate currency in this case euro.

anybody can explain to me the misery in the book??

thanks very much

#2

A little out of my FRA comfort zone here, but I beleive CIRP is saying that an investor should get the same return whether they invest in the Euro interest bearing instrument or the US one. In your example, for example, a Frenchman would have to convert Euros to USD to get the higher rate in the US. If CIRP holds, then he would lose out that extra yield when re-converting the USD back to Eur becuase the USD depreciated and he now must pay more to convert back to Euro. If he could get the higher interest rate in the US, AND convert back to the EUR with the dollar Appreciating, then he would be double-ing up. Extra interest and gain from currency exchange. In theory he shouldn’t be able to do this. if he could, I think the play would be buy USD, sell forward USD (same day). Invest in US. And you have a risk free profit.

Anyone else, am I thinking about this right?

#3

40yo, thanks very much for the explaination and kind reply.

maybe I am thinking too much from a practical point of view, but I definitely miss what the theory is suggesting.

let’s see the real situation, today December 2016. I am the Frenchman with 1m euro to convert them in USD at 1.0976 from google finance, so now I have 1,097,000 USD

t-bill 1 yr is 0.65%

euro 1 yr assumed to be 0.0% or maybe even negative.

after one year I got 1,097,000 * 1.0065 = 1,104,130 USD and want to convert it back to euro

now the theory is saying that the forward rate EUR/USD is set so I can not make profit for sure when I convert back to euro, so the forward rate USD/EUR should be 1.10473 so euro is stronger than USD.

but in our daily conversation, we are saying FED is raising interest rate, with expectation to raise too in the future. In Europe Draghi is printing money making QE, the economy is not recovering. And if we look at euro for last 1/2 years it is depreciating!!! And expectation for it is euro will go under the parity with USD, so how is possible that “the Frenchman” in this case after 1 year will make no profit if he invest I USD. To put in simple words, if the theory is true, why the market expectation for euro today is to depreciate…it should appreciate if I wanna follow the theory, really confused.

#4

I don’t know Are you saying that a Euro investor can get a return above the risk free rate with no risk? This is what no-arbitrage pricing is supposed to prevent. Maybe you are on to something. I say skip the CFA and open your own shop!

I am a mere CPA, not a fancy finance guy. The book says this shouldn’t happen…lol

#5

I wrote an article on this that may be of some help here: http://financialexamhelp123.com/covered-interest-rate-parity-irp-pricing-currency-forwards/

#6

You guys trying to explaing the real world with a single theory. Exchange rates are almost erractic, many variables influence its path to the extent is practically impossible to predict its movements.

Momentop, what you describing is the Uncovered Interest Rate Parity , not the CIRP. be careful with that. In order the Uncovered interest rate parity to hold, the currency with the highest interest rate must depreciate, simple. Check the math, (This does not happen in the real world of course). Curriculum 2016 , Book 1 page 525, last paragraph.

#7

Harrogath, thanks. I did as you said, went through the pages 525, 526. In fact it is explained that the uncovered does not work in the shirt or medium term, in fact fx carry trade are made to exploit this opportunity.

I wish on subject complex like fx, the book should explain first the short coming of theories, and provide more real situation examples.

Thank all all for the explanation

#8

Exactly, FX carry trades have proved to be a good source of profits for many years just because parities does not hold in the short or middle term.

I think you should be patient with the theories lol, they make sense after looking at the whole picture. Finish the chapter and hit eoc questions to fix your knowledge, it works well.

Good luck!