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While I'm sensitive to the overall point of this article the currency appreciation part is an inevitable consequence of domestic interest rates there. To see w
by danteembermage 15y ago
While I'm sensitive to the overall point of this article the currency appreciation part is an inevitable consequence of domestic interest rates there.
To see why, suppose I have 0 Yen in the form of a 100 Yen note and a 100 Yen loan. Further suppose that the domestic real interest rate is 0 (this is approximately true and will make the math easier, but know this follows even if the interest rate is positive but smaller). As holder of Yen debt and cash, if I invest in a 10 year Yen CD I'd have 100 - 100 = 0 Yen after 10 years time. Alternatively, suppose I convert to dollars at $1 per 100 Yen, invest the $1 in a 10 year CD paying 10% every decade compounded every decade (interest rates are usually quoted in different units but again this will make the math easier). I will owe 100 Yen and I will have $1.10. I can lock in all these transactions today, and other than counter-party risk I will have $1.10 and 100 Yen. If I enter into a contract promising to trade dollars for Yen in the future (this would be a "forward" contract but that's just terminology) the agreed upon future exchange rate had better be $1.10 for 100 Yen for some hedge fundie is about to make free money. So the easy way to make your currency rise 65% is to pay no interest.
This seems like an impossible contradiction until you think though what you would have to do to capitalize on this, slash interest rates. So while this would lead to currency appreciation against other currencies in the long term, it would cause a drastic drop in the short term.
tl;dr; the easiest way to rapidly increase your elevation is to dig a hole with some stairs
- Natsu 15y ago> tl;dr; the easiest way to rapidly increase your elevation is to dig a hole with some stairs Your explanation was interesting, but you totally lost me with that analogy.
- meric 15y agoI'd have thought raising interest rates would increase the currency's price. Higher interest rate - more money converted to the currency to take advantage of the interest rate, and so the currency becomes more expensive.
- danteembermage 15y agoThat is correct, if you raise interest rates you get a sudden and immediate increase in the value of your currency, followed by a slow decline, instead of a sudden decline followed by a long term increase. That's why the increase could be misleading, if XYZ currency goes from trading at the same price as the $US to trading at 1/10 the price and slowly increase up to 1/2 it is true that at some point over the life of the currency it has increased 500% but I wouldn't call that an argument in favor of the economic health of the country. That's essentially what would happen if you drastically slash interest rates as Japan did.
- justincormack 15y agoJust because forward rates are calculated as a risk free arbitrage does not mean the yen has to appreciate.
- danteembermage 15y agoI know it's surprising but it kinda does. If the forward exchange rates were always higher and the spot rates were always flat you could: Promise to sell 100 Yen for in the future $1.10 Wait Buy 100 Yen for $1.00 since the rate didn't change Sell 100 Yen for $1.10 and pocket $0.10 This strategy is by no means arbitrage but given those assumptions it would be profitable on average given those assumptions. So in general, currencies with low interest rates appreciate against currencies with high interest rates over time once the expectations about that currency's rate have reached a stable equilibrium. That last part is important as new information about lower rates would drastically drop the value of a currency just like you'd expect it to.
- justincormack 15y agoYes but currencies dont stay flat and it is not clear that there is such a thing as equilibrium in the markets.