Saturday, September 5, 2009

The principle of interest-rate parity(2)

To illustrate the principal of interest-rate parity, suppose interest rates in a foreign country are 3 percent above those in the United States. Then the currency of that foreign nation will, in equilibrium, sell at a 3 percent discount in the forward exchange market. Similarly, if interest rates are 1 percent lower abroad than in the United States, in equilibrium the foreign currency of the nations involved should sell at a 1 percent premium against the dollar. When such an equilibrium position is reached, movements of funds between nations even with currency risks covered do not generate excess returns relative to domestic investments of comparable risk. Capital funds tend to stay in the domestic market rather than flowing abroad.
It is when interest parity does not exist that capital tends to flow across national boundaries in response to differences in domestic and foreign interest rates. For example, suppose interest rates in a foreign nation are 3 percent above U.S. interest rates on securities of comparable quality and the foreign currency involved is selling at 1 percent discount against the dollar in the forward-exchange market. In this case, investing abroad with exchange risks covered will yield the investor a net return of 2 percent per year. Clearly, there is appositive incentive to invest overseas. In the absence of exchange controls, capital will flow abroad.
Is this situation likely to persist for a long period of time? No, because the movement of funds into a country offering higher interest rates tends to increase the forward discount on its currency and lowers the net interest returns to the investor. Other factors held constant, the flow of funds abroad eventually will subside, and capital funds will tend to stay at home until further changes in currency prices and interest rates take place.

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