How National Interest Rates Influence Currency Value and Exchange Rates
Interest rates, inflation, and currency exchange rates are intricately connected and heavily interdependent. Central banks play a crucial role in managing these variables through various monetary policies, including the manipulation of interest rates. This article explores how changes in national interest rates affect the value of a currency and exchange rates, following the principles of interest rate parity (IRP).
Effects of Sudden Changes in Interest Rates
When a country unexpectedly lowers its interest rates, the value of its currency tends to depreciate. The converse is also true: if interest rates unexpectedly rise, the currency's value is likely to appreciate. This phenomenon is due to the interplay between higher interest rates and the attractiveness of a country’s financial assets.
For example, if Brazil’s interest rates are much higher than those in the US, investors might flock towards Brazilian real (BRL) assets in pursuit of higher returns. However, a sudden cut in Brazil’s interest rates can cause a swift depreciation of BRL due to a shift in investor preference for safer assets.
Interest Rate Parity
Interest rate parity (IRP) is a fundamental concept in international finance theory. It posits that the difference between the interest rates of two nations should be equal to the difference between the forward and spot exchange rates between their respective currencies. Let’s break down how IRP works with a real-world example involving US investors and Pakistan.
US Investor Case Study: Pakistan's T-Bills
Suppose a US investor is considering a risk-free 90-day Pakistani Treasury Bill (T-Bill) with a nominal annual return of 7.3019%. The quarterly interest rate for this T-Bill would be 7.3019% / 4 1.8255%. At the same time, the spot exchange rate for the Pakistani Rupee (PKR) is 0.009416, meaning 0.006269 dollars can be exchanged for 1 PKR, resulting in 159.5073 PKR per dollar.
If the 90-day forward exchange rate is 0.009295, then 1 PKR can be exchanged for 0.006176 dollars, or 161.9157 PKR per dollar in 90 days. An investor with 1000 dollars can exchange them for 159507.30 PKR in the spot market. By investing this amount in a 90-day Pakistani T-Bill with a quarterly return of 1.8255%, the investment will generate 162,419.11 PKR in 90 days.
The key question is how much of this investment can be converted to dollars in 90 days. If the forward exchange rate holds, the investor will exchange 162,419.11 PKR for 1003.11 dollars. This gives an expected 90-day return of 103.11 dollars, or 3.11% in nominal terms. The return can be split into two components: the 1.8255% coming from the bond itself and the additional 1.24% arising from the belief that the PKR will appreciate relative to the US dollar.
Conclusion
The relationship between national interest rates, currency value, and exchange rates is not straightforward. Changes in interest rates can lead to unexpected shifts in currency values, which can have significant impacts on international trade and investment. Understanding these dynamics through the lens of interest rate parity is crucial for both policymakers and investors. By monitoring these variables, one can make more informed decisions regarding international financial investments and trade.
Keywords: Interest Rates, Currency Value, Exchange Rates