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I am reading the following Article at Investopedia which states

Generally, higher interest rates increase the value of a given country's currency. The higher interest rates that can be earned tend to attract foreign investment, increasing the demand for and value of the home country's currency. Conversely, lower interest rates tend to be unattractive for foreign investment and decrease the currency's relative value.

I do not understand why Higher Rates would attract Foreign Investors, therefore unable to see how they can profit from it.

How does this work, and what are some of the common ways Foreign Investors use this to their advantage?

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  • $\begingroup$ Look up the following LINK, it really helped me. quora.com/… $\endgroup$ – SIddharth Dec 25 '16 at 13:39
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The answer lies in this part of your posted quote:

"The higher interest rates that can be earned tend to attract foreign investment, increasing the demand for and value of the home country's currency."

Foreign investors would be attracted to the higher interest rate if they are able to receive a better return on their investment than they would get from their local market.

It sounds like your confusion might arise from the fact that a higher interest rate would mean the borrower has to pay out more in interest. Your quote refers to investors, the party receiving the higher interest payments.

A common way in which foreign investors would use higher interest rates to their advantage is by borrowing money locally at a lower rate and investing it in foreign markets at a higher rate. Profits would be calculated based on the difference in interest on the money (in a simplified situation). A more realistic scenario would also include exchange rate fluctuations and other variables.

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  • $\begingroup$ still makes no sense. It seems like the same principal would still apply as it does to buying foreign goods as it does to buying their currency. Can't wrap my head around this $\endgroup$ – user10697 Oct 12 '16 at 16:33
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    $\begingroup$ One example of the investment strategy: en.wikipedia.org/wiki/Carry_(investment)#Currency $\endgroup$ – Anton Tarasenko Oct 13 '16 at 22:15
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Suppose two countries. Let's call them A and B.

Suppose, for simplicity, that the exchange rate between these two countries is 1. Further, suppose both countries have the same inflation rate and same nominal interest rate (and thus the same real interest rate).

Now, suppose that country A, for whatever reason, triggers a contractionary monetary policy. The central bank of country A enacts this policy by selling securities in the open market. These securities sells cause a sharp increase in supply of securities. Given a relatively inelastic demand, this forces securities prices downs and yields up. That is to say - this action causes interest rates to rise. A rising interest rate is considered contractionary because it slows investment.

So now we have two countries, A and B, with a 1:1 exchange rate but now country A has a higher real interest rate than does country B. Assume it cost nothing for people in country B to invest in securities in country A.

We can reasonably expect people in country B, facing a 1:1 fixed exchange rate and no cost of moving capital, to buy Country A securities. Why? Because the securities in country A are more profitable because they offer a higher yield. That is to say - they are more profitable because of the higher prevailing interest rate in country A.

So, contractionary policy in country A raised interest rates (to slow investment). This interest rate hike made securities in country A more profitable than they were before the interest rate hike. This increase in the profitability in the securities of country A induced investments from people in Country B.


Hopefully that helps.

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Two Assumptions are necessary here

  1. Exchange rates are fixed i.e lets say the exchange rate for pounds to dollars is 1/4
  2. Price levels are relative to one another i.e lets say a basket of goods (which are homogeneous in both countries ) costs 1 pound in the UK and 4 dollars in the US.

When one goes and sees that the interest rate is higher in the US relative to the UK, meaning he will be able to purchase more from his investment in the US compared to the UK, the Investor will choose to invest his funds in US stock or bonds.

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A basic sketch is like this:

Suppose the interest rate in the US is 3% and the interest rate in the UK is 3%. But then the rate in the UK increases to 4%. How will people respond to this?

Lots of the people with money sitting in American banks are going to want to withdraw their money and deposit in a British bank (where they are paid a higher interest rate) instead.

In order to do this, they need to convert their dollars into pounds that the British bank will accept. Since they are selling dollars and buying pounds, the supply of the former and the demand for the latter increases, which is why the value of the pound relative to the dollar increases (the exchange rate is determined by supply and demand just like an ordinary price).

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Higher interest rates could mean: 1) More risk of default by government 2) More risk of currency depreciation/devaluation 3) Arbitrage opportunity

Assuming no arbitrage of course, higher interest rates due to credit risk would increase diversification opportunities to foreign investors seeking risky assets, due to correlation influences on portfolio. This will hence increase the attraction of these assets to a wider investor pool.

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