**3. THE INTEREST RATE APPROACH & THE FISHER EFFECT**

The connection between currency exchange rates and interest rate differentials appeared after the end of the Bretton Woods agreement in 1970-1972 (► What is Bretton Woods).

The interest-rate models assume that the global capital enjoys perfect mobility and that it will immediately take advantage of any interest rate differentials. A situation is known as ‘Covered Interest Rate Arbitrage’.

**Covered Interest Rate Arbitrage **

According to covered interest rate arbitrage theory, the interest-rate arbitrage is always active and ensures the covered interest rate parity worldwide.

**Interest Rate Parity (IRP)**

Interest Rate Parity (IRP) assumes that the interest rate differential between the two countries remains always equal to the differential calculated by using the forward exchange rate and the spot exchange rate. In other words, an exchange rate’s forward premium/discount equals its interest rate differential:

■ Forward premium/discount (%) = interest rate differential (%)

This creates an equilibrium based on the relationship between exchange rates and interest rates.

### Covered vs Uncovered Interest Rate Parity

Defining the covered and uncovered interest rate parity:

#### (1) Covered Interest Rate Parity (CIP)

Covered interest rate parity assumes that forward exchange rates are a function of current spot rates and interest rates

#### (2) Uncovered Interest Rate Parity

Uncovered interest rate parity assumes that the expected future spot rate is a function of the current spot rate and the interest rates of each currency (valid only in the absence of Forward contracts)

Empirical research has shown that the uncovered interest rate parity holds better than the covered interest rate parity.

#### Formulating the Interest Rate Parity

The interest rate parity links interest rates, spot exchange, and forward exchange rates. The exchange rates are adjusting to the changing ﬁnancial conditions as follows:

■ Interest Rate Parity = (1 + *i** _{d}*) = (S / F) x (1 +

*i*

*)*

_{f}Where:

*id*is the domestic interest rate (or the base currency)*if*is the foreign interest rate (or the quoted currency)- F is the forward foreign exchange rate
*S*is the current spot foreign exchange rate

If we solve the equation for the Forward foreign exchange rate

■ Forward Foreign Exchange Rate = S x {(1 + i_{f}) / (1 + i_{d})}

**The Fisher Effect & the International Fisher Effect**

#### The Fisher Effect

The Fisher effect theory suggests that differences in the nominal interest rates between two economies equal the expected changes of inflation rates.

■ Interest rate differentials = Expected inﬂation rates differentials

According to the PPP principle, the exchange rates, and the inﬂation rates are linked.

The Fisher effect links exchange rates and inflation rates with interest rates.

#### The International Fisher Effect

The international Fisher effect (or Fisher's open hypothesis) is a hypothesis that suggests differences in nominal interest rates between two economies equal the expected changes in the spot exchange rates of those countries.

■ Interest rate differentials = Expected change in the spot exchange

**Linking All Theories Together**

By linking all theories together:

(i) Spot and forward rates differentials = interest rates differential (*Interest rate parity theory*)

(ii) Interest rates differential = expected inﬂation rates differential (*Fisher effect*)

(iii) Expected inﬂation rates differential = expected change in the spot exchange rate (*Purchasing Power Parity*)

(iv) Interest rates differential = expected change in the spot exchange rate (*International Fisher effect*)

**Comparing Theory and Practice **(Based on Empirical Evidence)

Although the relationship between interest rates differential and the exchange rates seem logical, in practice things are different. In practice, interest rate differentials and future spot exchange rates are sometimes positively and some other times negatively correlated. These are some facts based on empirical evidence:

- 90% of the aggregate market volume has speculative characteristics and that means that the key market movers ignore the long-term effect of interest rate differentials
- The Foreign Exchange market is aligned with interest rate differentials but it tends to anticipate the movements of interest rates before they actually happen
- The Foreign Exchange market focus on many other factors except interest rates differentials and inflation rates. These factors include political stability, new legislation, new growth opportunities, business conditions, etc.
- The Interest Rate Parity and the two Fisher theories hold better for emerging economies. Developed economies are in general more complicated than emerging economies.

__Macroeconomics__:

- THEORIES: » Exchange Rate Theories | » Modern Monetary Theory | » Triffin Dilemma
- MODELS: » Purchasing Power Parity (PPP) | » Portfolio Balance Approach | » Monetary Approach | » Balance of Payments Approach

■ THE INTEREST RATE APPROACH

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