Reading 21 - Currency Management - Impact of an increase in the Interest Rate

CFA Level III Portfolio Management
#1

Hi fellow CFAs,

i am confused with regards to the impact of the interest rate increase by a central bank country A (assume that capital flows freely between markets).

The first impact of such action is an increased capital influx. Hence, Currency A will appreciate against the other currencies.

on the other hand, under the Interest Rate Parity, if interest A is say 8% and interest B (for country B) is say 5%, the market expects the currency of country B to appreciate by 3% (%Delta Spot A/B = interest A - Interest B). which seems to contradict my above sentence.

Can somebody please help me with this? is it related to the Short Term effect VS the Long Term one?

Thank you

#2

Your first scenario assumes a possibility of arbitrage and no parity conditions. Also, in your first scenario if your Central bank raises rates, other global banks will choose to convert their currency to the domestic to lend out and earn a higher rate of return.

In the second scenario, no arbitrage assumption is made based on uncovered parity which would prevent you from earning incremental returns on currency due to mispricing as it is expected to correct in the future.