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I'm reading Investopedia's How National Interest Rates Affect Currency Values and Exchange Rates to understand how interest rates affect exchange rates.

It says:

Generally, higher interest rates increase the value of a country's currency. Higher interest rates tend to attract foreign investment, increasing the demand for and value of the home country's currency.

And:

When the Federal Reserve raises the federal funds rate, interest rates across the broad fixed income securities market increase as well. These higher yields become more attractive to investors, both domestically and abroad.

I don't fully understand this.

In what follows EUR/USD exchange rates are taken from FRED, Federal Funds Effective Rate are also taken from FRED, and ECB interest rate are taken from ECB website.

Suppose I'm a EU citizen, and in August 2006 I have $100 €$.

For the sake of simplicity, suppose I invest at the ECB interest rate, which in 2006 was 3%. I invest it for 5 years. In August 2011 I have $100\cdot(1+0.05)^5=115.93 €$. I gained $15.93 €$ in interests.

In August 2006 the FED had just risen interest rates. In fact FED's rate equal $5.25\%$, more than ECB rate.

I then convert my EUR in USD. The exchange rate EUR/USD in Aug 2006 equals $1.2793$. My $100€$ are then converted to $ 100€*1.2793\frac{$}{€}=127.93\,{$} $. I invest in 5 years at FED's rate. In August 2011 I have

\begin{equation} 127.93\,{$} \cdot (1+0.0525)^5 = 165.23\, {$} . \end{equation}

Now I'm in Europe and Europe's sellers want euros. So I convert my dollars back in euros. In August 2011 the EUR/USD exchange rate is $1.4406$.

I then have $$ 165.23\,{$} \div 1.4406 \frac{$}{€} = 114.69 € .$$

I gained $14.69 €$ in interests, $1.23 €$ less than what I have gained if I had invested in euro-denominated bonds.

Said otherwise, if my buying USD bonds increase the exchange rate, either I transfer to the US at maturity or the higher exchange rate will go against me at maturity.

Where am I wrong?

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  • $\begingroup$ I don't know why it renders a newline after "165.23". $\endgroup$ Aug 16, 2023 at 22:08

1 Answer 1

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There are a lot of false assumptions here. A probably incomplete list:

  • You (implicitly) assume is that the Investopedia article is telling the whole story (Investopedia is not particularly reliable)
  • The statement refers to the time period you are looking at
  • You get the same short term interest rate for a period of 5 years
  • The FED Funds Rate and USD bonds do have the same interest rate.

In reality:

  • The Feds Funds rate is an overnight rate that changes constantly (that you as a retail investor could not even invest in).
  • Higher interest rates increase the value of a currency immediately, not over a period of time.
  • In fact, higher interest rates will lead to a decline in the FX rate over time (according to interest rate parity).
  • Exchange rates do not simply follow such a pre-determined path (even if interest rates would never again change). They largely, and especially in the EURUSD example follow a random walk (details here).
  • There is a Cross Currency Basis when trading floating rates between currencies because no one can actually borrow and lend freely in USD (what rate even? SOFR, Fed Funds, Libor pre cessation date, Euribor, ESTR,...)
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  • $\begingroup$ Regarding the first one, so what is the whole story? Regarding the other points, whatever interest rates we take, and whatever time period we take, the point is: if the (in the example) US central bank raises interest rates, the US bond interest rate raises, and I convert my euros to invest in US bonds, the exchange rate raises (because I sell euros and I buy USD), but then at maturity I have to convert the USD back into euros, at the higher exchange rate, and it might happen that I would have been better off if I had invested in the (lower yielding) euro bonds. [CONT] $\endgroup$ Aug 20, 2023 at 10:45
  • $\begingroup$ [CONT] So I should not invest in the US bonds in the first place. Again US and Europe are examples. $\endgroup$ Aug 20, 2023 at 10:46
  • $\begingroup$ Interest parity states it shouldn't matter. Higher interest rates are offset by depreciation in the currency. Rate hikes can increase or decrease exchange rates because it all depends what was expected and priced in. In reality, no one knows because FX rates are very close to random walks (unless you look at high inflation countries). $\endgroup$
    – AKdemy
    Aug 20, 2023 at 10:58

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