Interest Rate Parity, Forward Rates & International Fisher Effect

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  • 0:02 Background on Foreign…
  • 0:53 What Is Interest Rate Parity?
  • 2:26 The International…
  • 3:18 Interest Arbitrage
  • 4:40 Lesson Summary
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Lesson Transcript
Instructor: Natalie Boyd

Natalie is a teacher and holds an MA in English Education and is in progress on her PhD in psychology.

How do interest rates affect companies that do business in multiple countries? In this lesson, we'll look at exchange and interest rates, including interest rate parity, the international Fisher effect, and interest arbitrage.

Background on Foreign Exchange Rates

Johanna owns a company that does business overseas. That means they receive money in foreign currencies, like euros or Japanese yen, and then they have to convert the money to US dollars. When they convert it, though, it doesn't convert exactly one to one. In other words, one euro is not the same as one US dollar (or one Japanese yen).

The exchange rate is the value of one currency against another. For example, one euro might be worth $1.20. The spot exchange rate is the current exchange rate, but Johanna's company sometimes also deals with the forward exchange rate, which is a forecasted future exchange rate.

To help Johanna understand the different exchange rates and how her company can make money using exchange rates, let's take a look at international rate parity, the international Fisher effect, and interest arbitrage.

What Is Interest Rate Parity?

Johanna's company receives money from different countries in the local currencies. She has two major choices: she can invest that money locally or convert it to US dollars and invest it in US accounts. What should she do?

The answer to that question is that it depends. One thing that can influence her decision is the interest rates of different countries. For example, the interest rate in the UK is different from that of the US and that of Japan. If Johanna receives euros (or British pounds) from a client in the UK, the interest rates in the UK and US, as well as the exchange rate, might affect her decision of where to invest.

Interest rate parity is when the difference between interest rates between two countries is equal to the difference in the spot and forward exchange rates. A more common variation is that of uncovered interest rate parity, which occurs when the difference between interest rates is equal to the difference in the spot exchange rate.

What does this mean? Imagine that interest rates in the UK are 5% lower than that of the US. In other words, Johanna's investments in the UK will earn 5% less than they would if they were in US investments. In that case, the exchange rate should indicate that the US dollar is 5% lower than the UK pound.

The point of interest rate parity is that it doesn't matter whether Johanna exchanges the money and invests in US investments or if she keeps it in the UK and invests there. The result will be the same, because the difference in interest rates and exchange rates are equal. Another way of saying that two things are equal is to say that they have achieved parity, which is where the name comes from.

The International Fisher Effect

It makes sense to Johanna that the exchange rate and interest rates are connected; after all, if she exchanges foreign currency for US dollars, she wants the end result to be equal. And Johanna's not the only one who wants interest rate parity, so the international Fisher effect (named for the economist who first described it) says that changes in the exchange rate have to do with expected differences in interest rates. That is, the market will react to try to achieve uncovered interest rate parity.

Let's look at an example. Imagine that experts are anticipating that the difference in the US and UK interest rates will decrease, so that the US interest rate is only 3% higher than that of the UK (instead of the 5% we talked about before). According to the international Fisher effect, the forward exchange rate will also change so that the difference between the UK pound and US dollar is 3% instead of 5%.

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