Parity Conditions in
International Finance
International Fisher Effect
The Fisher Effect
Nominal interest rate is made up of two
components
– A real required rate of return
– An inflation premium equal to the expected amount
of inflation
• (1 + rn ) = (1 + rr) (1 + i)
The generalized version of the Fisher effect
says that real returns are equalized across
countries through arbitrage
If expected real returns are higher in one
country than another, capital will flow from
country with lower real returns to a country
with higher real returns
This process will continue until returns are
equalized across countries
In equilibrium, with no government
interference, nominal interest rate differential
will approximately equal the the anticipated
inflation differential
Thus, currencies with high inflation rates
should bear higher interest rates than
currencies with lower low inflation rates
This relationship between anticipated
exchange rate movements and the nominal
level of interest rates is called the
International Fisher Effect.
If domestic interest rates exceed foreign
interest rates, then the foreign currency must
appreciate enough (or domestic currency
must depreciate enough) to offset any benefit
of higher interest rates in home country for
the foreigners
If domestic interest rates are less than
foreign interest rates, then the foreign
currency must depreciate enough to offset
any benefit of higher interest rates in foreign
country for the domestic investor
Lessons of IFE
Anticipated exchange rate changes can be
derived from inspecting differences in nominal
interest rates
The actual return to investors who invest in
money market securities in their home country is
simply the interest rate offered on those
securities in their home country
The actual return to investors who invest in
foreign money market securities depends on not
only the foreign interest rate, but also on the
percentage change in the value of foreign
currency.
Lessons of IFE
Effective return on home investment
should on an average be equal to the
effective return on a foreign investment
Why IFE may not hold?