CFA Level II ExamEconomicsEasy
A financial analyst is evaluating the potential impact of an increase in the domestic interest rate on a country's exchange rate, assuming all other factors remain constant. The analyst is specifically interested in the short-term effects based on the interest rate parity condition. Which of the following is the most likely immediate effect on the domestic currency?
- ANo immediate change, as exchange rates are primarily driven by long-term economic fundamentals.
- BDepreciation, as foreign investors withdraw capital due to higher borrowing costs.
- CDepreciation, as the central bank would likely intervene to prevent an excessive capital inflow.
- DAppreciation, as higher domestic interest rates attract foreign capital seeking better returns.
Show answer & explanationAnswer & explanation
Correct answer: D. Appreciation, as higher domestic interest rates attract foreign capital seeking better returns.
According to interest rate parity, a higher domestic interest rate, all else being equal, makes domestic assets more attractive to foreign investors. This increased demand for domestic currency to invest in these assets leads to an appreciation of the domestic currency in the short term.
Why the other options are wrong
- A. Incorrect. While long-term fundamentals are crucial, interest rate differentials can have significant short-term impacts on exchange rates.
- B. Incorrect. Higher domestic interest rates typically attract, not deter, foreign capital.
- C. Incorrect. While central banks can intervene, the initial market mechanism driven by interest rate differentials would be appreciation, not depreciation, and intervention is not the primary short-term effect.
Interest Rate Parity (IRP)
A no-arbitrage condition stating that the difference in interest rates between two countries is equal to the difference between the forward exchange rate and the spot exchange rate.
- Suggests that investors should be indifferent to investing in either country's assets if IRP holds.
- Predicts the relationship between spot and forward exchange rates.
- Often holds in the short term for highly liquid currencies.
Memory trick: Interest Rates Lure Funds, Boosting Currency Value.