Page 82 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 5: Currency Forecasting

return and anticipated inflation. The nominal interest rate would also incorporate the default Notes
risk of an investment.
It is often argued that an increase in a country’s interest rates tends to increase the exchange
value of its currency by inducing capital inflows. However, the IFE argues that a rise in a
country’s nominal interest rate relative to the nominal interest rates of other countries indicates
that the exchange value of the country’s currency is expected to fall. This is due to the increase in
the country’s expected inflation and not due to the increase in the nominal interest rate.

!
Caution The IFE implies that if the nominal interest rate does not sufficiently increase to
maintain the real interest rate, the exchange value of the country’s currency tends to
decline even further.

Graphic Analysis of the International Fisher

Figure 5.2 illustrates the IFE. The X axis shows the percentage change in the foreign currency’s
spot rate while the Y axis shows the difference between the home interest rate and the foreign
interest rate (I – I ). The diagonal line indicates the IFE line and depicts the exchange rate
h f
adjustment to offset the differential in interest rates. For all points on the IFE line, an investor
will end up achieving the same yield (adjusted for exchange rate fluctuations) whether investing
at home or in a foreign country.

Point A in the Figure 5.2 shows a situation where the foreign interest exceeds the home interest
rate by 4 percentage points, yet, the foreign currency depreciates by 4 per cent to offset its
interest rate advantage. This would mean that an investor setting up a deposit in the foreign
country would have achieved a return similar to what was possible domestically. Point B
represents a home interest rate 3 per cent above the foreign interest rate. If investors from the
home country establish a foreign deposit, they will be at a disadvantage regarding the foreign
interest rate. But the IFE theory suggests that the currency should appreciate by 3 per cent to
offset the interest rate disadvantage.

Figure 5.2: Illustration of IFE Line
(When Exchange Rate Changes Perfectly Offset Interest Rate Differentials)

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