OK so this is more than confusing to say the least. I am trying to understand what the effect of a CHANGE in interest rates between two countries would be on interest rate parity. Assume that GBPUSD is 1.50, interest rate in USD is 10% in GBP is 5% => IRP states that over time USD should depreciate by the differential (5%) making the new GBP rate 1.575 QUESTIONS 1) If the interest rate differential changes, what happens to the spot price? Will it change or would it just be the expected future rate changing? E.g. if the USD rate changes to 15% then I imagine the spot (from that point on) would be expected to depreciate an additional 5% in future 2) Is the depreciation infinite? All the examples I look at state that the exchange rate should converge to the forward rate. But once it has depreciated by the amount of the differential over one year (assuming an annual rate) will it continue to do so for the next year? If this holds then eventually one of the currencies would become worthless (with all other factors constant) Obviously all of this is totally counter intuitive to what actually happens, most of the time a currencies spot rate appreciates when interest rates increase and vice versa…with the forward rates factoring in the new difference due to arbitrage. But IRP doesn’t explain any of this…help!
algo-rhythm Wrote: ------------------------------------------------------- > OK so this is more than confusing to say the > least. I am trying to understand what the effect > of a CHANGE in interest rates between two > countries would be on interest rate parity. > > Assume that GBPUSD is 1.50, interest rate in USD > is 10% in GBP is 5% > > => IRP states that over time USD should depreciate > by the differential (5%) making the new GBP rate > 1.575 > > QUESTIONS > > > 1) If the interest rate differential changes, what > happens to the spot price? Can’t tell if the nominal differential changes. If the real differential changes, increased demand for higher real-yielding currency causes it to appreciate. This has nothing to do with interest rate parity (IRP). > Will it change or > would it just be the expected future rate > changing? E.g. if the USD rate changes to 15% > then I imagine the spot (from that point on) would > be expected to depreciate an additional 5% in > future > The forward market would instantly reprice forward contracts if risk-free USD rates went to 15%. > 2) Is the depreciation infinite? All the examples > I look at state that the exchange rate should > converge to the forward rate. There is no theorem that says that forward rates = expected spot rates and the question is empirical. There is a huge mountain of research on it and reasonable people can disagree. It’s closer than you would probably think though. > But once it has > depreciated by the amount of the differential over > one year (assuming an annual rate) will it > continue to do so for the next year? There is pressure for spot rates to move toward forward rates, but succesful carry trades can happen for years. How long was the yen carry trade successful for? (Ans: At least 10 years). The yen carry trade was about betting that the yen did not appreciate as much as IRP says it should. Theoretically, the carry trade should go away because the carry itself creates demand that should increase interest rates. For a variety of reasons, that didn’t happen mostly because the Japanese seemed to be able to provide an infinite supply of money to borrow. > If this holds > then eventually one of the currencies would become > worthless (with all other factors constant) > Really high nominal interest rates can certainly be portents of currency devaluations. IRP is pretty tenuous at really high interest rates because at really high interest rates risk-free lending doesn’t really happen and there are all kinds of other risks added to the picture that make arbitrage not work and derail the uncovered version of the theory. > Obviously all of this is totally counter intuitive > to what actually happens, most of the time a > currencies spot rate appreciates when interest > rates increase and vice versa… Says who? It’s only true if you add “real rates” and then you have some work to do. Interest rates change because of monetary reasons as well as demand reasons. > with the forward > rates factoring in the new difference due to > arbitrage. But IRP doesn’t explain any of > this…help! IRP explains traded forward pricing completely and is all about nominal prices. These economic effects are all about real supply/demand and returns.
Thanks very much for your comprehensive answers. I have been trying to pull everything together I study with what I read about and witness - yen carry trade being one of them. So in summary: IRP is all about nominal prices and interest rates…equalling each other out So what would cause a change in real interest rates? Most central banks have a mandate of price stability, e.g the ECB. So, if they raise interest rates it is implied that it is due to an increase in their inflation expectations…in which case there should be no reason to want to invest in the higher yielding euro as it would be eaten away by inflation…e.g. no chane in rea linterst rates…but the currency moves.
Not my best thing - but I think real interest rates primarily change because of demand for money due to economic growth.
The internally Fisher theory assume the real interest is the same all around the world. That’s how you got the (1+ra)/(1+rb)=(1+Ia)/(1+Ib) thing. But seriously, is there anyone in the word try to base on their investments on these lousy formulas?
I found one sentence in the CFAI which seems to explain this. Esentailly because the interest is certain but the associated currency depreciation is not certain investors are still prepared to take a punt. A change in real interest rates is due to the view on expected inflation changes…a change in rates due to already known inflation would just be a change in nominal rates. Same principal, essentially these equations are all based on the relationship between current and expected variables, with the excpetion of covered arbitrage where the expected rate is locked into a forward contract and can therefore be arbitraged. I have no idea how FX traders model any of this stuff…it all seems so wishy washy!
The IFT only assumes that investors “demand” the same return, the inflation premium and future spot rate are the unknown variable. If the differential is not large you can simply use I(home) - I(foreign). In practice, the IFT does NOT hold, I doubt people are basing there recommendations on this “formula”