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Below i attached the interest rate parity condition in terms of exhange rates. enter image description here

Below i attached the interest rate parity condition in terms of exhange rates. enter image description here

The national interest rate is the euro and the foreign interest rate is the dollar.

So i know that if the national interest rate is equal to the foreign interest rate, the exchange rate is equal to the expected exchange rate.

But i dont understand what happens when the national interest rate is higher than the foreign interest rate.

I know mathematically that if that is the case, then the exchange rate will be higher than the expected exchange rate. First question , But why is it so logically?

Second question :Can you tell me if i'm wrong :

if the national interest rate is higher than the foreign interest rate, then

-this leads to a depreciation of the exchange rate in the future since the expected exchange rate is lower that the current exchange rate.

Third question:Now what happens to the currencies ? What currency appreciates/ depreciates and why ? If the national IR is higher than the foreign one, in which bond would the investor invest in ?

Can you maybe show a numerical, simple example since im new to interest rates and finance ? Thanks!

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It is not clear to me that you are thinking about this formula correctly.

The uncovered interest rate parity formula is used to help judge if forward exchange rates fairly reflect interest rate differentials.

For example, suppose we wish to look at EURUSD one month forward. We begin by looking up the spot fx rate. We would then consult the interest rate markets to get both the USD and EUR interest rates for one month forward. Next we plug in the spot rate and interest rates into the formula and solve for the forward fx rate. Finally we would compare the forward fx rate calculated by the interest rate parity formula to the forward fx rate in the current market. If there is a difference, then this would suggest that there is opportunity for arbitrage or hedging fx risk (or speculating, for that matter). If the calculated forward rate is higher than the current market forward rate, this would suggest we "sell", and conversely "buy". On the other hand, if the difference is zero or very small, then this suggests that there is no opportunity for arbitrage.

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  • Thanks for the help . However the professor explained the change in IRs in terms of the formula of the interest rate parity ... – GGGG Nov 24 '19 at 19:59
  • @GGGG Yes, you can use the formula in that way too. Plug in the spot and forward rates, then solve for the ratio (1+i)/(i+j). Then, again, depending on what the current forward interest rate markets say, buy or sell interest rate contracts on any difference between the calculated ratio and the actual ratio of forward interest rate market rates. – user41790 Nov 24 '19 at 20:17
  • CAn you tell me if what I wrote is correct and help me with the questions? – GGGG Nov 24 '19 at 20:45

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