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Hi John, In the interest rate parity formula which is denoted by Spot rate x (1+ih)/(1+if). Could you please explain me how the domestic currency depreciates when the risk free rate of the domestic currency is high with that against the foreign currency.
I assume that you are asking because it does not seem logical – you would expect people to move their money to the country with the higher interest rate and therefore the exchange rate to move in the other direction.
However, the following points are relevant (and you need to think about them together rather than individually).
1 In practice lots of things affect exchange rates, and it is therefore impossible to forecast them accurately – it is just that relative interest rates (and inflation rates) are things we can actually measure.
2 The current exchange rate will already have taken into account the relative interest and inflation rates.
3 Interest rates are not regarded as a particularly good predictor of exchange rates – inflation rates are regarded as better. That is why in the exam (and on the formula sheet) we use inflation rates to forecast exchange rates (when needed).
In theory, inflation rates and interest rates move together which is why (in the exam) we would use interest rates if inflation rates were not available.4 The interest rate parity formula is used to calculate forward rates (which is why F is used as a symbol in the formula). Forward rates are NOT a forecast by the bank – they are calculated (in practice) by the banks using the relative interest rates.
The reason for this is that what happens with forward rates is that the bank ‘pools’ all the money on which people want a forward rate, and then the bank uses the money markets.
The result of money market hedging must (in practice) be the same as the result using forward rates. (In the exam you are often asked to do both and say which is best, but in real life the results must be identical (apart from bank commissions). If they were not identical then you could make money by arranging a money market deal and a reverse forward rate deal 🙂 )I hope that makes sense – especially point 4 which is the really important one. I assume that you are happy with money market hedging, but if not then watch my lecture where I try and explain the point about forward rates not being a ‘guess’ but being calculated using the relative interest rates.
(If you want me to answer, then it is better to ask questions in the Ask the Tutor Forum. I do not always have the time to read the general forums which are more for students to help each other 🙂 )
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