c
m
 
 


 
m 

An economic theory that states that an expected change in the current exchange rate between any
two currencies is approximately equivalent to the difference between the two countries' nominal interest
rates for that time.

Calculated as:

Where:
"E" represents the % change in the exchange rate
"i1" represents country A's interest rate
"i2" represents country B's interest rate

m  

 m
 
  

 
m 
For example, if country A's interest rate is 10% and country B's interest rate is 5%, country B's currency
should appreciate roughly 5% compared to country A's currency.

The rational for the IFE is that a country with a higher interest rate will also tend to have a higher inflation
rate. This increased amount of inflation should cause the currency in the country with the high interest
rate to depreciate against a country with lower interest rates.
0

 

 
 
 

 





  



 


 !

 




 

 "

 




 

 

 
 
  

 #  
 "
 
 !


 



#

 


#
#

   




a 

The decision to use a pure interest rate model rather than an inflation model or some combination stems
from the assumption by Fisher that real interest rates are not affected by changes in expected inflation
rates because both will become equalized over time through market arbitrage; inflation
is embedded within the interest rate and factored into market projections for a currency price. It is
assumed that spot currency prices will naturally achieve parity with perfect ordering markets. This is
known as the Fisher Effect and not to be confused with the International Fisher Effect. (To learn more
about interest rate models and how they relate to currency, check out a


   

 
a  .)

Fisher believed the pure interest rate model was more of a leading indicator that predicts future spot
currency prices 12 months in the future. The minor problem with this assumption is that we can't ever
know with certainty over time the spot price or the exact interest rate. This is known as uncovered interest
parity. The question for modern studies is: does the International Fisher Effect work now that currencies
are allowed to free float. From the 1930s to the 1970s we didn't have an answer because nations
controlled their currency price for economic and trade purposes. This begs the question: has credence
been given to a model that hasn't really been fully tested? Yet the vast majority of studies only
concentrated on one nation and compared that nation to the United States currency.

0 a 0 ma

The Fisher Effect model says nominal interest rates reflect the real rate of return and expected rathe of
inflation. So the difference between real and nominal rates of interest is determined by expected rates of
inflation. The approximate nominal rate of return = real rate of return plus the expected rate of inflation.
For example, if the real rate of return is 3.5% and expected inflation is 5.4 % then the approximate
nominal rate of return is 0.035 + 0.054.= 0.089 or 8.9%. The precise formula is (1 + nominal rate) = (1 +
real rate) x (1 + inflation rate), which would equal 9.1% in this example. The IFE takes this example one
step further to assume appreciation or depreciation of currency prices is proportionally related to
differences in nominal rates of interest. Nominal interest rates would automatically reflect differences in
inflation by a purchasing power parity or no-arbitrage system.

0 ma 
For example, suppose the GBP/USD spot exchange rate is 1.5339 and the current interest rate in the
U.S. is 5% and 7% in Great Britain. The IFE predicts that the country with the higher nominal interest rate
(GBP in this case) will see its currency depreciate. The expected future spot rate is calculated by
multiplying the spot rate by a ratio of the foreign interest rate to domestic interest rate: (1.5339 X
(1.07/1.05) = 1.5631. The IFE expects the GBP/USD to appreciate to 1.5631 and the USD/GBP to
depreciate to 0.6398 so that investors in either currency will achieve the same average return i.e. an
investor in USD will earn a lower interest rate of 5% but will also gain from appreciation of the USD.

For the shorter term, the IFE is generally unreliable because of the numerous short-term factors that
affect exchange rates and the predictions of nominal rates and inflation. Longer-term International Fisher
Effects have proven a bit better, but not by very much. Exchange rates eventually offset interest rate
differentials, but prediction errors often occur. Remember that we are trying to predict the spot rate in the
future. IFE fails particularly when the costs of borrowing or expected returns differ, or when purchasing
power parity fails. This is defined when the cost of goods can't be exchanged in each nation on a one-for-
one basis after adjusting for exchange rate changes and inflation. (Learn about one metric used to gauge
price parity between nations in ´ 

    )

J  
Today, we don't normally see the big interest rate changes we have seen in the past. One point or even
half point nominal interest rate changes rarely occur. Instead, the focus for central bankers in the modern
day is not an interest rate target, but rather an inflation target where interest rates are determined by the
expected rate of inflation. Central bankers focus on their nation's Consumer Price Index (CPI) to measure
prices and adjust interest rates according to prices in an economy. To do otherwise may cause an
economy to fall into deflation or stop a growing economy from further growth. The Fisher models may not
be practical to implement in your daily currency trades, but their usefulness lies in their ability to illustrate
the expected relationship between interest rates, inflation and exchange rates

m
 
  


  

 

  





 




#

#  




 

 
 

 



#




"# 


 

 
 # 

#
 





0 
   #
  $ 



%

0

  
 







  


  



#
  
  






&
  
"


 # 

#
 



# 

  

#

 
 







 
# 


 

'(

m 

a 

Both the Interest Rate Parity theory and the Purchasing Power Parity theory allows us to estimate the
future expected exchange rate. The Interest Rate Parity theory relates exchange rate with risk free
interest rates while the Purchasing Power Parity theory relates exchange rate with inflation rates. Putting
them together basically tell us that risk free interest rates are related to inflation rates.
0  

 

 
0

 

 

 








&
  
)