Interest Rate Parity
(Most used source for this chapter)
Assuming a forward market exists, the investor can either save at home, receiving interest rate i, or converting by the exchange rate S , receiving interest rate i* abroad, and then converting back to home currency by the forward rate F obtaining at time t for a trade at time t+1.
This condition is called “covered interest rate parity”, reflecting the fact that investors are “covered” against nominal uncertainty by way of the forward market.
If the gross return of foreign investments converted in local currency is higher than the return of investments in the home country, then investors will prefer the foreign currency investments.
If the forward rate is equal to the future spot rate (see also “forward premium”) such that
then we obtain the “uncovered interest rate parity”:
In countries with high inflation, money is not worth always the same. Money in this currency loses real (i.e. inflation-adjusted) value, you can buy less with it after some time Therefore the ex-ante purchasing power parity, suggests that these currencies depreciate over the long-term.
The p terms stand for foreign expected prices minus current prices, i.g. foreign inflation, compared with the p* terms, local inflation.
On the other side, it is possible that despite higher inflation, a foreign currency does not depreciate. The reason is that investments in this currency yield more. This is reflected in the real interest parity.
Higher yields on investments (“marginal product of capital”) compensate for the fact that inflation is higher.
Since the central banks need to combat high inflation, they are obliged to hike interest rates until they are equal to the yield of investments minus a risk premium. Neoclassical models assume that the marginal product of capital equals the real interest rate, this condition is equivalent to the equalization of marginal products of capital equalized across borders.
Real Interest Rate and Fisher equation
The Fisher equation leads to the definition of real interest rates.
The following graph shows real interest rates around the world based on central bank interest rates as December 2012.
(click to expand)
Disclaimer: The opinions expressed above are not intended to be taken as investment advice. It is to be taken as opinion only and we encourage you to complete your own due diligence when making an investment decision. Even if we often write about Forex trading, our advices aren't written for day traders who follow technical channels, but rather for mid- and long-term investors. Our aim is to show discrepancies between fundamental data and current asset valuations, which can lead in mid-term to an inversion to technical channels.
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