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Dear Mr John,
Pleae help to explain the following.
The interest rate parity model shows that it may be possible to predict exchange rate movements by referring to differences in nominal interest rate. If the forward exchange rate for sterling against the dollar was no higher than the spot rate but US nominal interest rate were higher , the following would happen:
– UK investors would shift funds to the US in order to secure the higher interest rates, since they would suffer no exchange losses when they converted $ back into UK$.
– the flow of capital from the UK to the US would raise U.K. interest rate and force up the spot rate for the US$.Thank you very much.
For forecasting spot rate, we use the PPP formula – we use inflation rates, not interest rates.
The IRP formula is used to calculate the forward rates – they are not the same as the future spot rates.
In theory, the two should give the same result (because in theory inflation rates go up and down in line with interest rates), but in practice the two are not the same.
I explain all this in my free lectures.
The lectures are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well.
Dear Mr John,
Thank you for reply with good explanation.
But I still don’t understand the second point above as to ‘force up the spot rate for the US$’. Is the spot rate depreciating or appreciating? And Why?
Thank you very much.
The flow of capital to the US would mean higher demand for $’s (and lower demand for Pounds). So the US $ would strengthen (and be more expensive against the Pound) – i.e. a higher spot rate.
Dear Mr John,
Thank you for the clear explanation.
If UK interest rates raise, its currency is subjected to depreciation according to IRPT. Will UK investors suffer any exchange loss when converted back to pound? Why?
Thank you for your explanation.
I must clarify my previous answer, because it depends which way round the exchange rate is quoted.
Certainly higher interest rates in the US will mean that the dollar will strengthen which will mean the 1 pound will buy fewer dollars.
Therefore the Pound/$ (i.e. the pounds that 1$ will buy) exchange rate will increase, or the $/Pound (i.e the $’s that 1pound will buy) exchange rate will fall.Also, do appreciate what I wrote in my first reply, that although in theory interest rates and inflation rates should move up and down together, in practice then although that will be the case in the long-term, it is not necessarily the case in the short-term. IRP is always used to calculate forward rates, however for forecasting future spot rate then PPP is a better predictor and in the exam we always use PPP for forecasting future spot rates.
Do please watch my free lectures 🙂
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