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In 2016, the ECB has lowered interest rate to 0%. Some people assume that within the next few years, the ECB will increase the interest rate.

How would that most probably affect the EUR/USD exchange ratio?

Or more generally and abstracting other factors, how does the ECB/FED interest rate usually affect the EUR/USD ratio?

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If you're talking current exchange rate, it won't. It will affect future exchange rates as the euro deflates because of interest rates.

In general, the future expected exchange rate is the current exchange rate times the ratio of the numerator's interest rate to the denominator's interest rate (adjusted for timeframe).

Or mathematically:

f(EUR/USD) = EUR/USD * (1+r(ECB)) / (1+r(FED))

So as the ECB rate increases, the future expected exchange rate will increase (assuming a stable FED rate).

That said, these expected rate increases are ALREADY priced into future exchange rates, so unless you think the rate will increase but the market does not, you CANNOT profit off of this in the FX market.

  • Thanks so much for your answer! In the formula, is it supposed to read as 1+r(FED) or 1-r(FED)? – bonanza Oct 31 '18 at 7:09
  • I think there is a typo in the equation the _ should be a + Too few characters for me to edit – Mark Oct 31 '18 at 10:04
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    @bonanza 1+. Mark is correct- it was a typo. – D Stanley Oct 31 '18 at 13:05

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