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Theory suggests that as rates rise domestically, the home currency (call it currency A) will appreciate against currency B (all else equal).

What we see with currency forward rates though seems to be the opposite. If currency A's monetary authority sets higher rates than currency B, arbitrageurs have a risk-free opportunity to buy at the spot and invest in the higher-yielding currency and convert back.

Here is an example:

The spot rate on the New Zealand dollar (NZD) is NZD/USD 1.4286, and the 180-day forward rate is NZD?USD 1.3889. This difference means:
a. interest rates are lower in the US than in NZ
b. interest rates are higher in the US than in NZ
c. it takes more NZD to buy one USD in the forward market than in the spot market

The correct answer is said to be B. However, this isn't very intuitive if we look at it through the lens of rate policy alone. I'm probably missing something obvious.

Question

Why do these two views seem to suggest different outcomes and is there a preferred situation for either?

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  • $\begingroup$ There is a distinction between the covered interest rate parity no-arbitrage condition (which leads to the forward rate results and B) and the immediate change in spot exchange rates when interest rate differentials change implied by your first point. $\endgroup$ – Henry Mar 31 at 10:06

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