Fisher effect Simple Example
- 1. Interest Rates and Exchange Rates International Fisher Effect (IFE) Difference in nominal interest rates supported by two nations’ currencies will cause an equal but opposite change in their spot exchange rates “Nominal” interest rate = Real + Inflation
- 2. International Fisher Effect • The IFE predicts that the interest rate differential (using Nominal interest rates) is an unbiased predictor of future changes in the spot exchange rate. • Assuming: • The absence of government intervention. • Nominal interest rate differential should reflect expected change in exchange rate. • Currency with the lower nominal interest rate expected to appreciate relative to one with a higher nominal interest rate
- 3. Simple Version of the IFE 𝑆(𝑡+1) 𝑆𝑡 = 1 + 𝑖 𝑞 1 + 𝑖 𝑝 Where 𝑆(𝑡+1) is the Spot exchange rate of currency units of Q per currency units of P one year from now and 𝑆(𝑡) is the current exchange rate. 𝑖 𝑝 and 𝑖q are the respective nominal interest rates.
- 4. Calculating future spot rates • Country P : Real Int rate (Rrp)= 4%/yr, Inflation (Rip)= 5%/yr • Country Q : Real Int rate (Rrq) =5%/yr, Inflation (Riq)= 7%/yr • Current Exchange Rate, P = 1.5Q, • Nominal Rate for P = 9%, For Q = 12% • Using the simple version of the IFE 𝑆(𝑡+1) 1.5𝑄/𝑃 = 1+0.12 1+0.09 • Forward rate per unit of P = S(t+1) = (1.12/1.09) * 1.5 Q = 1.54 Q
- 5. Example The real interest rate on South Korean government securities with one-year maturity is 4% and the expected inflation rate for the coming year is 2%. The real interest rate on U.S. government securities with one-year maturity is 7% and the expected rate of inflation is 5%. The current spot exchange rate for Korea won is $1 = W1,200. Forecast the spot exchange rate one year from today.
- 6. Example Solution • We know that the nominal interest rate in the US is 12%, and in South Korea is 6%. • The international Fisher effect suggests that the exchange rate will change in an equal amount but opposite direction to the difference in nominal interest rates (currency with the higher nominal rate will get weaker). • Hence, since the nominal interest rate is higher in the US than in South Korea, the dollar should depreciate relative to the South Korean Won. In other words, 1US$ will buy fewer SK Won. • Using the simple IFE formula • Forward rate per 1$ = ((1+0.06)/(1+0.12))*1200 = W1,138