Higher rates and appreciating currency. Or not

CFA Level III Derivatives
#1

So according to los28d "increases in the value of a currency are associated with higher real or nominal interest rates. "

according to the same Los, now referring to the carry trade, it states " the currency with the higher interest rate will trade at a forward discount."

this is means that it should actually depreciated, correct?

some clarification would be much appreciated

#2

Hi,

I can perhaps try to answer this.

This is basic interest rate parity, it explains the relationship between interest rates and currency exchange rates. The basic premise of interest rate parity is that hedged returns from investing in different currencies should be the same, regardless of the level of their interest rates.

The answer to your question is yes. The currency with higher interest rate will have a lower forward rate (or trade at a forward discount) against another currency to make even, otherwise arbitrage opportunity exists.

Another way to look at it is that a currency with lower interest rates will trade at a forward premium in relation to a currency with a higher interest rate. In other words, there is no interest rate advantage if an investor borrows in a low-interest rate currency to invest in a currency offering a higher interest rate.

#3

Thank you, I see your point.

Maybe I’m thick, but why then does the earlier statement assert that a higher interest rate currency should appreciate but then later state that the higher interest rate currency depreciate?

#4

economics is much like astrology , just a bit worse at predictions!

A country with a strong economy may yet want to diversify and want to attract Foreign Direct Investment and knowhow. It may raise interest rates to attract capital. Investors may flock n when they realize that they can get good returns with low risk. The flows should elevate the currency relative to the investors own currency.

Very different case happens when the economy is doing poorly . As inflation picks up the county might raise rates to try and control it, but this might be perceived as anti-business and could be seen as anti-growth. if investors perceive higher risk in the future , they may leave inspite of the rate incentives. This will cause the currency to depreciae.

#5

There is some doubt how interest rates that are increasing due to inflation affect the exchange rate of the country. For example in Reading 28 Vol 4 page 247 the analyst believe that the india authorities will pursue tighter monetary policy and the answer suggest that this should lead to higher real interest rate. Tighter monetary policy point to the authority trying to cool the economy and may lead to increase in volatility. In the circunstance it is not clear how this will lead to higher real rate. I would appreaiate some assistance to understand the rationale.

#6

Real rates should rise as monetary policy is tightened. But with inflation expected to be curtailed foreign investors may like the better yields and bid up the currency. In the short term there could be volatility as the market adjusts to the changed policy

#7

Hi, I’m confused about this concept too. So in Econimic fundamental approach, it’s saying higher interest rate would lead to currency value appreciation. But in the carry trade, it’s saying higher interest rate would lead to currency value to decrease. So don’t these 2 theories contradict each other? How should I answer a question if a question is asked like “what happenes to value of curency when interest rate raise?” Can someone help out and explain?

#8

Hi:

I believe it is the following:

In the Economics part, due to interest rate parity, the currency with the higher interest rate is expected to depreciate against the currency with the lower interest rate. As a result, the forward contracts are priced to reflect the expected decrease as a result of interest rate parity.

However, people who are involved with the carry trade look for and bid up the currency with the higher interest rate, because they believe that the uncovered interest rate parity will not hold. Thus, the currency with the higher interest rate could be expected to appreciate if many individuals pile into the carry trade. BUT, if there is increased currency volatility, then many individuals may try to unwind their carry trade at the same time, causing a hasty depreciation in the currency with the higher interest rate.

#9

Sorry to bump an old thread but I am encountering this problem. Based on the below question, wouldn’t it be confusing as to whether we should assume that in option C, the euro should appreciate or depreciate in light of the rising real interest rate?

  1. Which of the following statements about volatility and interest rates is most likely true? A. Falling currency volatility leads traders to exit a carry trade. B. Rising currency volatility will increase the cost of a collar more than the cost of a protective put. C. A delta neutral hedging strategy is more likely to tilt to a net long position in the euro when the euro zone is experiencing rising real interest rates.

You could of course say A and B are clearly wrong and that leaves C with the only answer but what if this was a true / false question based on C alone.

Thank you.