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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Johanna thinks that, in general, interest rate parity is a good thing for her business. After all, it means that whether she exchanges foreign currency for US dollars or not, the end result will be the same. But, she wonders if there's a way to use exchange rates to make money.
The short answer is yes, because the exchange rate between two countries is unique to only those two countries. Thus, some companies use interest arbitrage to make money. This is when companies (or individuals) trade money across different currencies, using exchange rates to make a profit.
Let's look at an example. Johanna's company makes 1,000 British pounds through their business in the UK. Because of the exchange rate, this is like 1,050 US dollars. So Johanna can exchange the pounds for dollars and be on her way.
But wait! There's another way because the exchange rate for euros to dollars is actually better than the exchange rate for pounds to dollars. So, Johanna can exchange the 1,000 pounds for 900 euros, and then exchange the 900 euros for 1,150 dollars. She's made a profit of $100 just by changing the money from pounds to euros and then to dollars!
Still, arbitrage doesn't come without risks, and timing is important. Johanna can try to minimize some of these risks with covered interest arbitrage, which uses a forward contract to set a predetermined forward exchange rate for selling currency.
The exchange rate is the value of one currency against another. The spot exchange rate is the current exchange rate, while the forward exchange rate is a forecasted future exchange rate. 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. The international Fisher effect 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. Interest arbitrage occurs when companies (or individuals) trade money across different currencies, using exchange rates to make a profit. Covered interest arbitrage uses a forward contract to minimize exchange rate risk.
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