The effect of interest rates on exchange rates

CFA Level III Portfolio Management
#1

I’m having some difficulty to grasp the following conflicting theories:

  • The economic perspective of currency management suggest that a higher interest rate in a country tends to be associated with appreciation of its currency, i.e. a positive relationship between the domestic currency and domestic interest rate.

  • Interest Rate Parity (IRP), however, suggests a country with higher interest rates will see depreciation of its currency relative to a country with lower interest rates. This is a negative relationship between the domestic currency and domestic interest rate.

Let me know if my understanding of both concepts are correct.

#2

There are lots of forces that act on currency exchange rates; there’s not reason that they all have to act in the same direction.

#3

You are correct.

Higher rates = appreciation as we’d know it in real life. However, IRP is trying to say you get the same return regardless of whether you invest abroad or at home. Thus, if rates were higher elsewhere you expect a depreciation to thus make that return the same as at home.

#4

Additional explanation from Schweser relating to the economic approach:

“Higher interest rates generally attract capital and increase the domestic currency value. At some level though, higher interest rates will result in lower currency values because the high rates may stifle an economy and make it less attractive to invest there.”