In reading 13, the curriculum states that the currency with the higher interest rate in that country is expected to depreciate. This is the opposite of what I have been taught in the past. For example, the Feds today announced they will increase the interest rates. I therefore expect the USD to increase vs the CAD as Canadian interest rates remain low. So in this case, the USD (which has the higher interest rate) is expected to appreciate. Can someone please briefly explain why my thought with the USD example is contradictory to what I just read in reading 13?
Thanks!
I was also confused last year about this.
The idea behind your argument is that a cut in short-term interest rates will discourage investors, which will decrease the demand for the local currency and decrease the currency’s value.
The idea behind the other argument is that a cut in short-term interest rates may promote growth of the economy and the attractiveness of the local stocks, and thus increasing the local currency’s value.
This makes the Central Bank’s job more difficult to stabilize/predict the movement of the local currency.
Source: CFA L3 Schweser Capital Market Expectations
There are many forces that act on currency exchange rates, not all in the same direction.
You’re talking about interest rate parity, which is not a particularly strong force. Investor demand for currencies is much stronger, and generally acts in the opposite direction of IRP.
You know the way I’ve always understood it is as interest rates rise in some currency (e.g., the USD), more money flocks to that currency TODAY to take advantage of the higher interest rate (as we see the EUR/USD approaching $1 parity). Thus, spot prices in the higher interest rate currency must go up. Because that currency will eventually need to be sold forward to convert back into your particular currency, the forward price will be inundated with investors “selling” the currency forward therefore dragging down the forward price. An example for illustration purposes: suppose my domestic currency is the Euro, but USD short-term rates are moving up while mine are going no where. What do I do? I sell my Euros spot and buy USD to invest at the USD’s higher interest rates, and enough people thinking like this would drive up the spot exchange rate. Because I’ll eventually need to get my Euros back, I’ll go into the forward market to sell forward the EUR/USD, locking in my price but contributing to the supply that might drive the forward price down. So relative to the increasing spot price, the forward price would be expected to decrease.
Forwards are priced under no-arbitrage rules and interest rate differentials right? So, shouldn’t that mean that despite any hot money buying euros/selling dollars forward the price should be unaffected by supply/demand dynamics?
Unless when performing such a carry trade in size the market bids down the yield on target currency government debt and affects the interest rate differentials that way?
Currencies aren’t my strong point so anyone please chip in if I am approaching this the wrong way!
Yes.
Forward rates are intended to prevent arbitrage, not to predict future exchange rates.