International Fisher Effect PDF

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University of Okara (Renala Khurd Campus)

Subject: International Finance Submitted to: Umaila Riaz Ahmad

Submitted by: Ishfaq Ameen (1038) MBA 6th Semester Morning Session (2017-2021) Department of management science August, 2020

International Fisher Effect (IFE) What Is the International Fisher Effect? The International Fisher Effect (IFE) is an economic theory stating that the expected disparity between the exchange rate of two currencies is approximately equal to the difference between their countries' nominal interest rates.  The International Fisher Effect (IFE) states that differences in nominal interest rates between countries can be used to predict changes in exchange rates.  According to the IFE, countries with higher nominal interest rates experience higher rates of inflation, which will result in currency depreciation against other currencies.  In practice, evidence for the IFE is mixed and in recent years direct estimation of currency exchange movements from expected inflation is more common.

Background of the International Fisher Effect: The International Fisher Effect, also known as the IFE or Fisher-Open Effect, is a popular and dominant hypothesis in finance. It came into existence courtesy of Irving Fisher, an important economist of the 1900s. He created the theory in the early 1930s. Irving also came up with two other theories that relate to the IFE; the Fisher Index and the Quantity Theory of Money. Collectively, the theories state that the levels of prices in an economy are directly proportional to the rate of inflation and the money supply.

Understanding the International Fisher Effect (IFE) The IFE is based on the analysis of interest rates associated with present and future risk-free investments, such as Treasuries, and is used to help predict currency movements. This is in contrast to other methods that solely use inflation rates in the prediction of exchange rate shifts, instead functioning as a combined view relating inflation and interest rates to a currency's appreciation or depreciation. The IFE provides for the assumption that countries with lower interest rates will likely also experience lower levels of inflation, which can result in increases in the real value of the associated currency when compared to other nations.

The Fisher Effect and the International Fisher Effect: The Fisher Effect and the IFE are related models but are not interchangeable. The Fisher Effect claims that the combination of the anticipated rate of inflation and the real rate of return are represented in the nominal interest rates. The IFE expands on the Fisher Effect, suggesting that because nominal interest rates reflect anticipated inflation rates and currency exchange rate changes are driven by inflation rates, then currency changes are proportionate to the difference between the two nations' nominal interest rates.

Calculating the International Fisher Effect IFE is calculated as:

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 rationale 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 a higher interest rate to depreciate against a country with lower interest rates.

Implications of the International Fisher Effect: The international Fisher effect (IFE) theory suggests that currencies with high interest rates will have high expected inflation and therefore will be expected to depreciate. The implications are that a firm that consistently purchases foreign Treasury bills will on average earn a similar return as on domestic Treasury bills. Therefore, MNCs and investors based in the United States may not necessarily attempt to invest in interest-bearing securities in those countries because the exchange rate effect could offset the interest rate advantage. The exchange rate effect is not expected to perfectly offset the interest rate advantage in every period. It could be less pronounced in some periods and more pronounced in other periods.

Implications of the IFE for Foreign Investors: The implications are similar for foreign investors who attempt to capitalize on relatively high U.S. interest rates. The foreign investors will be adversely affected by the effects of a relatively high U.S. inflation rate if they try to capitalize on the high U.S. interest rates. The nominal interest rate is 8 percent in the United States and 5 percent in Japan. The expected real rate of return is 2 percent in each country. The U.S. inflation rate is expected to be 6 percent, while the inflation rate in Japan is expected to be 3 percent. According to PPP theory, the Japanese yen is expected to appreciate by the expected inflation differential of 3 percent. If the exchange rate changes as expected, Japanese investors who attempt to capitalize on the higher U.S. interest rate will earn a return similar to what they could have earned in their own country. Though the U.S. interest rate is 3 percent higher, the Japanese investors will repurchase their yen at the end of the investment period for 3 percent more than the price at which they sold yen.

Therefore, their return from investing in the United States is no better than what they would have earned domestically.

Derivation of the International Fisher Effect: The precise relationship between the interest rate differential of two countries and the expected exchange rate change according to the IFE can be derived as follows. First, the actual return to investors who invest in money market securities (such as short-term bank deposits) in their home country is simply the interest rate offered on those securities. The actual return to investors who invest in a foreign money market security, however, depends on not only the foreign interest rate (if) but also the percentage change in the value of the foreign currency (ef) denominating the security. The formula for the actual or “effective” (exchange-rate-adjusted) return on a foreign bank deposit (or any money market security) is

As verified here, the IFE theory contends that when ih > if, ef will be positive because the relatively low foreign interest rate reflects relatively low inflationary expectations in the foreign country. That is, the foreign currency will appreciate when the foreign interest rate is lower than the home interest rate. This appreciation will improve the foreign return to investors from the home country, making returns on foreign securities similar to returns on home securities. Conversely, when if > ih, ef will be negative. That is, the foreign currency will depreciate when the foreign interest rate exceeds the home interest rate. This depreciation will reduce the return on foreign securities from the perspective of investors in the home country, making returns on foreign securities no higher than returns on home securities.

Numerical Example Based on the Derivation of IFE: Given two interest rates, the value of ef can be determined from the formula that was just derived and used to forecast the exchange rate.

Example: Assume that the interest rate on a 1-year insured home country bank deposit is 11 percent, and the interest rate on a 1-year insured foreign bank deposit is 12 percent. For the actual returns of these two investments to be similar from the perspective of investors in the home country, the foreign currency would have to change over the investment horizon by the following percentage:

The implications are that the foreign currency denominating the foreign deposit would need to depreciate by .89 percent to make the actual return on the foreign deposit equal to 11 percent from the perspective of investors in the home country. This would make the return on the foreign investment equal to the return on a domestic investment.

Comparison of the IRP, PPP, and IFE: Although all three theories relate to the determination of exchange rates, they have different implications.  IRP focuses on why the forward rate differs from the spot rate and on the degree of difference that should exist. It relates to a specific point in time.  PPP and IFE focus on how a currency’s spot rate will change over time.  Whereas PPP suggests that the spot rate will change in accordance with inflation differentials, IFE suggests that it will change in accordance with interest rate differentials.  PPP is related to IFE because expected inflation differentials influence the nominal interest rate differentials between two countries.

Some generalizations about countries can be made by applying these theories. Highinflation countries tend to have high nominal interest rates (due to the Fisher effect). Their currencies tend to weaken over time (because of the PPP and IFE), and the forward rates of their currencies normally exhibit large discounts (due to IRP). Financial managers that believe in PPP recognize that the exchange rate movement in any particular period will not always move according to the inflation differential between the two countries of concern. Yet, they may still rely on the inflation differential in order to derive their best guess of the expected exchange rate movement. Financial managers that believe in IFE recognize that the exchange rate movement in any particular period will not always move according to the interest rate differential between the two countries of concern. Yet, they may still rely on the interest rate differential in order to derive their best guess of the expected exchange rate movement.

Conclusion: Evidently, the IFE was an important and widely-used concept in the past century. However, due to changing financial and economic dynamics, it has lost some of its weight. Nevertheless, it remains useful in some fields such as forex trading and in making lending decisions. In a nutshell, it may have lost some of its relevance, but it is still in use by some sectors....