- This topic has 8 replies, 3 voices, and was last updated 4 years ago by
.
- Posts
Hello sir,
Can you please explain how high interest rates depreciates the currency relative to currency with low interest rate? And how interest rates reduce inflation? I can’t understand the mechanism!!
The relationships are the other way round 🙂
What Fisher hypothesised is the the higher the expected inflation rate, then the higher interest rate will be demanded by investors. (This does make sense – if you expect there to be high inflation then you will want higher interest to keep the value of your money intact).
With regard to exchange rates, if you watch my lecture on forecasting exchange rates (or look at the chapter in the Course Notes on here) then you will see an explanation with numbers of purchasing power parity, which predicts how the spot rate will change due to inflation rates in the two countries. Because (from my previous paragraph) interest rates and inflation rates are (in theory) linked, interest rates can be used to predict spot rates in the same way as inflation.
(We call them unbiased predictors, because inflation and interest rates are things we can measure. However, obviously all sorts of other factors will affect future spot rates and it is impossible to predict them accurately)
Thank You sir! I got the first part.
And can we take it like this too; when interest rates goes up, people invest in government bonds as its risk free and return is high. And eventually supply of money decreases inflation? Does it make sense?For the rest, I hope i’ll understand it too after reading your course notes.
And there’s one thing more I want to ask.. Are your course notes and lectures enough to pass the exam? Or reading the book is necessary? :p
Yes – that makes sense 🙂
The notes etc are enough to pass provided that you practise lots of questions. The more extra reading you are able to do then the better.
Ok. Thank you so much! 🙂
I’ve another query.. We have seen that as interest rates go up, the price of the IR future goes down which is opposite to currency futures. Is there any theoretical logic behind this?Yes – the reason is that there are no futures based directly on interest rates. They are based on the market value of short term government borrowings. As interest rates go up, the market value of debt goes down, and vice versa.
Thank you so much!!
And can you tell me that why does the value of currency future goes up as the spot goes up. It should go down as we can buy or sell currency at a high rate from the market, so in a way making futures useless! I know it depends on the value of underlying currency but why there is a positive relationship between them?A currency future is a bit like a forward rate – it is the right to convert at a fixed rate on a fixed future date (although that is not the way that they are normally used).
So just as you would expect forward rate to increase as the spot rate increases, so too you would expect the futures price to increase.
(Or, to put it another way, if you think that the exchange rate will increase you could buy currency to hopefully make a profit (and people buying would push up the rate), or instead you could buy futures to hopefully make a profit (and people buying futures would push up the rate).
- You must be logged in to reply to this topic.