The Relationship Between Exchange Rates, Interest Rates
The relationship between exchange rates, interest rates • In this lecture we will learn how exchange rates accommodate equilibrium in financial markets. For this purpose we examine the relationship between interest rates and exchange rates. Interest rates are the return to holding interest-bearing financial assets. In the previous lecture we have pointed out that as being a financial asset exchange rates tend to adjust more quickly to new information that goods prices. Like exchange rates, interest rates are also the prices of financial assets and hence adjust quickly to new information. • The profit-seeking arbitrage activity will bring about an interest parity relationship between interest rates of two countries and exchange rate between these countries. • A U.S. investor deciding between investing say in New York and in Tokyo must consider several things: – the interest rate in the U.S., i$ , (interest rate in aU.S¿ dollar denominated bond, or rate of return in a U.S. dollar denominated US stock etc), interest rate in Japan (iY ; – the spot exchange rate, S; and – the future exchange rate for maturity date, forward rate, F . • If the investor did not lock in a future exchange rate now, the unknown future spot exchange rate would make the investment risky. The investor can eliminate the uncertainty over the future dollar value of the investment by covering the investment with a forward exchange contract. • If the investor covers the investment with a forward contract the arbitrage between two investment opportunities results in a covered interest parity (CIP) condition: (1 + i$ ) = (1 + iY ) 1 F S (1)
which may be rewritten as (1 + i$ ) F = (1 + iY ) S (2)
• The interest rate parity equation can be approximated for small interest rates by: i$ − iY = F −S S (3)
• This later equation says that interest differential between a US denominated investment instrument and a Yen denominated investment instrument is equal to the forward premium or discount on the Yen. •
which may be rewritten as (1 + i$ ) F = (1 + iY ) S (2)
• The interest rate parity equation can be approximated for small interest rates by: i$ − iY = F −S S (3)
• This later equation says that interest differential between a US denominated investment instrument and a Yen denominated investment instrument is equal to the forward premium or discount on the Yen. •