International Fisher Effect 2 (brief summary) PDF

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Summary

Gives a brief description of the the theory [the international fisher effect]. It also describes how the theory works between countries....

Description

INTERNATIONAL FISHER EFFECT The International Fisher Effect is an exchange rate model designed by the U.S Economist Irving Fisher in the 1930s. Fisher argued that the expected disparity between the exchange rate of two currencies is approximately equal to the difference between their countries nominal interest rates. It is based on present and future risk free nominal interest rate rather than pure inflation, and it is used to predict and understand present and future spot currency price movements. The International Fisher Effect Theory was recognized on the basis that interest rates are independent of other monetary variables and that they provide a strong indication of how the currency of a specific country is performing. According to Fisher, changes in inflation do not impact real interest rates, since the real interest rate is simply the nominal rate minus inflation. The theory assumes that a country with lower interest rates will see lower levels of inflation which will translate to an increase in the real value of the country’s currency in comparison to another country’s currency. When interest rates are high, there will be higher levels of inflation which will result in the depreciation of the country’s currency. How to calculate the International Fisher Effect The formula for calculating the IFE is as follows: E = [(i1-i2) / (1+ i2)]  (i1-i2)

Where:   

E = Percentage change in the exchange rate of the country’s currency I1 = Country’s A’s Interest rate I2 = Country’s B’s Interest rate

Example

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Let’s take the example of two currencies, the USD (the United States) and the CAD (the Canadian Dollar). The USD/CAD spot exchange rate is 1.30, and the interest rate of the United States is 5.0% while that of Canada is 6.0%. Based on the IFE assumption, the country with a higher interest rate, Canada in this case, will see a higher inflation rate and will experience a depreciation of its currency. The future spot rate is calculated by taking the spot rate and multiplying it by the ratio of the foreign interest rate to the domestic interest rate, as shown below:

1.3 x (1.05/1.06) = 1.312

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Given the future spot rate, the International Fisher Effect assumes that the CAD currency will depreciate against the USD. 1 USD will exchange into 1.312 CAD, up from the original rate of 1.30. On one hand, investors will receive a lower interest rate on the USD currency, but on the other hand, they will gain from an increase in the value of the US currency. Application of the International Fisher Effect in the real world

Banks lending decisions The International Fisher Effect can be an important tool when making lending decisions. Since the formula takes inflation into consideration, it helps lenders in knowing whether their products will be profitable in the long run. In this way, they can determine the appropriate interest rates to charge on loans and other items.

Financial Trading Finally, financial traders such as forex traders can benefit from the data derived from the IFE. If they know that the currency of a specific country is about to appreciate, then they get ready to open long (buy trades). Similarly, if they see that the value is going to depreciate, then they prepare to open short (sell trades). Limitations of the International Fisher Effect It makes long term predictions only

One of the major limitations of the IFE is that it can only make forecasts for the long term. Therefore it cannot be used in analyzing financial performances for periods of less than one year. Uncovered Interest parity The second but very crucial limitation of the IFE is known as the uncovered interest parity. This means that, while it can make almost accurate currency movement predictions, it has no method of telling when the effects will start. As such, while it might make true conclusions, the users cannot have a specific time to watch. It can therefore be said to be unreliable in giving specific timelines....