Under covered and uncovered interest rate parity, the currency with the higher nominal interest rate will depreciate against the currency with the lower interest rate so that the higher interest rate achieved will be offset by a depreciating currency.
Why then, when you look at the FOREX market does a currency appreciate when interest rates are thought to increase? For example if CPI numbers come back above expectations then the currency will appreciate or if the central bank of that currency is hawkish to increase rates the currency will appreciate. This seems to be the opposite of what covered and uncovered interest rate parity are saying, in that the currency with the higher interest rate will depreciate.
I always thought that higher interest rates caused an appreciation of the currency due to demand for those interest rates and hence an inflow of capital to the higher interest rate earning currency.
If CIP no longer works does that mean that uncovered interest rate parity also doesn’t work?
And also, what is the intuition behind CIP and UIP in that a higher interest rate would cause depreciation? was the intuition that real rates would remain in equilibrium or that higher nominal interest rates had some effect on inflation?
Interest rate parity only works with non-volatile interest rates, and other assumptions, like no central bank action, country risk premium, or other supply/demand factors. So in other words, it doesn’t really work well in real life.
Suppose that the 6-month risk-free rate is 2%, and the spot price of GOOG 1,075. Do you really expect that in 6 months the spot price of GOOG will be 1,085.70? Do you really expect that my forward contract will have any influence on the price of GOOG in 6 months?
