Fisher Equation

[lev]

Remember Fisher Equation: F/S = (1+Rd)/(1+Rf), where F and S are expressed as a direct quote (DC/FC). What this equation is telling us is that if domestic rates are higher than foreign rates, then F > S. Given that Forward Rates are unbiased predictors of future spot rates, this means that domestic currency should cost less in one year, i.e. depreciate relative to current spot rates. For example, say you are a resident of the U.S. and the following info is given: S = 1.02 USD / 1 EUR, Rd = 5%, Rf = 2%. This implies that in one year the exchange rate should be 1.05 USD / 1 EUR, i.e. domestic currency has depreciated.

This contradicts the economic notion that countries with higher interest rates would attract foreign investment and this will result in domestic currency appreciating. Anyone want to take a stab at it?

 

[shadefx]

nobel prize

 

[JoeyDVivre]

How about this stab? Nobody thinks that higher risk-free rates attracts foreign investment because of the currency problem (balance of payments issues matter here but are beyond the scope). Any foreign investor in a different currency would look at his return in his domestic currency using forward currency rates.

Now higher risky investment rates is a different story. Thus, the implied repo rates for two currencies may be similar, but the return on risky debt may be very different. Or maybe not, because capital markets know stuff like this and move money to where it's needed.

Isn't it a cool world?

 

[lev]

JV, agree with your second paragraph, but why is it again that the risk-free rate is irrelevant in attracting foreign investment? Aren�t the flatness of the yield curve and current account deficit caused by exactly that � the demand for 30 yr T-bonds by foreign governments which kinda hope to realize a risk-free rate?



Edited 2 time(s). Last edit at Wednesday, June 14, 2006 at 11:15AM by lev.