T HE I NTERNATIONAL F ISHER E FFECT

FINANCIAL MANAGEMENT

4.4 T HE I NTERNATIONAL F ISHER E FFECT

By late 1995, Quebec’s separatists had lost their referendum for independence, the federal and provincial governments began slashing their budget deficits and planned even bigger cuts in the future, and Canada’s largest province, Ontario, announced large tax cuts as well. Perceived political risk declined, and investors began focusing on Canada’s low inflation rate. As a result of these favorable trends, the Canadian dollar strengthened and, in early 1996, short-term Canadian interest rates fell below U.S.

rates, after having stayed above U.S. rates for more than a decade. But the yield on 10-year Canadian government bonds stayed about 1 percentage point above that on U.S. Treasuries. With continued low inflation, however, by late 1997, Canada paid about 0.5 percentage pointslessfor 10-year money than did the United States.

Before we move to the next parity condition, a caveat is in order. We must keep in mind that there are numerous interest differentials just as there are many different interest rates in a market. The rate on bank deposits, for instance, will not be identical to that on Treasury bills.

In computation of an interest differential, therefore, the securities on which this differential is based must be of identical risk characteristics save for currency risk. Otherwise, there is the danger of comparing apples with oranges (or at least temple oranges with navel oranges).

Adding Up Capital Markets Internationally. Central to understanding how we can add yen and euro and dollar capital markets together is to recognize that money is only a veil: All financial transactions, no matter how complex, ultimately involve exchanges of goods today for goods in the future. As we will see in Chapter 5, you supply credit (capital) when you consume less than you produce; you demand credit when you consume more than you produce. Thus, the supply of credit can be thought of as the excess supply of goods and the demand for credit as the excess demand for goods. When we add up the capital markets around the world, we are adding up the excess demands for goods and the excess supplies of goods. A car is still a car, whether it is valued in yen or dollars.

Illustration

Using the IFE to Forecast US$and SFr Rates In July, the one-year interest rate is 2% on Swiss francs and 7% on U.S. dollars.

a. If the current exchange rate is SFr 1=$0.91, what is the expected future exchange rate in one year?

Solution.According to the international Fisher effect, the spot exchange rate expected in one year equals 0.91×1.07/1.02=$0.9546.

b. If a change in expectations regarding future U.S. inflation causes the expected future spot rate to rise to $1.00, what should happen to the U.S. interest rate?

Solution.Ifr_usis the unknown U.S. interest rate, and the Swiss interest rate stayed at 4% (because there has been no change in expectations of Swiss inflation), then according to the international Fisher effect, 1.00/0.91=(1+r_us)/1.02, orr_us=11.21%.

If r_f is relatively small, Equation 4.16 provides a reasonable approximation to the international Fisher effect:¹²

r_h−r_f = e₁−e₀

e₀ (4.16)

In effect, the IFE says thatcurrencies with low interest rates are expected to appreciate relative to currencies with high interest rates.

A graph of Equation 4.16 is shown in Exhibit 4.13. The vertical axis shows the expected change in the home currency value of the foreign currency, and the horizontal axis shows the

Exhibit 4.13 International Fisher Effect

5 4 3 2 1

–1 –2 –3 –4 –5

1 –1

–2 –3 –4

–5 2 3 4 5

F

E Expected change in

home currency value of foreign currency (%)

Parity line

Interest differential in favor of home country (%)

12Subtracting 1 from both sides of Equation 4.15 yields^(e1_e^−e0)

0 =^rh₁₊⁻_rf^rf. Equation 4.16 follows ifr_fis relatively small.

interest differential between the two countries for the same time period. The parity line shows all points for whichr_h−r_f =(e₁−e₀)/e0.

Point E is a position of equilibrium because it lies on the parity line, with the 4% interest differential in favor of the home country just offset by the anticipated 4% appreciation in the HC value of the foreign currency. Point F, however, illustrates a situation of disequilibrium.

If the foreign currency is expected to appreciate by 3% in terms of the HC, but the interest differential in favor of the home country is only 2%, then funds would flow from the home to the foreign country to take advantage of the higher exchange-adjusted returns there. This capital flow will continue until exchange-adjusted returns are equal in the two nations.

Essentially what the IFE says is that arbitrage between financial markets—in the form of international capital flows—should ensure that the interest differential between any two countries is an unbiased predictor of the future change in the spot rate of exchange. This condition does not mean, however, that the interest differential is an especially accurate predictor; it just means that prediction errors tend to cancel out over time. Moreover, an implicit assumption that underlies IFE is that investors view foreign and domestic assets as perfect substitutes. To the extent that this condition is violated (see the discussion on the Fisher effect) and investors require a risk premium (in the form of a higher expected real return) to hold foreign assets, IFE will not hold exactly.

Empirical Evidence

As predicted, there is a clear tendency for currencies with high interest rates (for example, Mexico and Brazil) to depreciate and those with low interest rates (for example, Japan and Switzerland) to appreciate. The ability of interest differentials to anticipate currency changes is supported by several empirical studies that indicate the long-run tendency for these differentials to offset exchange rate changes.¹³The international Fisher effect also appears to hold even in the short run in the case of nations facing very rapid rates of inflation. Thus, at any given time, currencies bearing higher nominal interest rates can be reasonably expected to depreciate relative to currencies bearing lower interest rates.

Despite this apparently convincing evidence for the international Fisher effect, a large body of empirical evidence now indicates that the IFE does not hold up very well in the short run for nations with low to moderate rates of inflation.¹⁴ One possible explanation for this result relies on the existence of a time-varying exchange risk premium. However, this explanation for the failure of the IFE to hold in the short run has been challenged by empirical evidence indicating that the currency risk premium, to the extent it exists, is very small.¹⁵

A more plausible explanation for the IFE’s failure in the short run relies on the nature of the Fisher effect. According to the Fisher effect, changes in the nominal interest differential can result from changes in either the real interest differential or relative inflationary expectations.

These two possibilities have opposite effects on currency values. For example, suppose that the nominal interest differential widens in favor of the United States. If this spread is due to a rise in the real interest rate in the United States relative to that of other countries, the value of the dollar will rise. Alternatively, if the change in the nominal interest differential is caused by an increase in inflationary expectations for the United States, the dollar’s value will drop.

The key to understanding short-run changes in the value of the dollar or other currency, then, is to distinguish changes in nominal interest rate differentials that are caused by changes

13See, for example, Ian H. Giddy and Gunter Dufey, ‘‘The Random Behavior of Flexible Exchange Rates,’’ Journal of International Business Studies(Spring 1975): 1–32; and Robert A. Aliber and Clyde P. Stickney, ‘‘Accounting Measures of Foreign Exchange Exposure: The Long and Short of It,’’The Accounting Review(January 1975): 44–57.

14Much of this research is summarized in Kenneth A. Froot, ‘‘Short Rates and Expected Asset Returns,’’ NBER Working Paper No. 3247, January 1990.

15See, for example, Kenneth A. Froot and Jeffrey A. Frankel, ‘‘Forward Discount Bias: Is It an Exchange Risk Premium?’’

Quarterly Journal of Economics(February 1989): 139–161.

in real interest rate differentials from those caused by changes in relative inflation expectations.

Historically, changes in the nominal interest differential have been dominated, at times, by changes in the real interest differential; at other times, they have been dominated by changes in relative inflation expectations. Consequently, there is no stable, predictable relationship between changes in the nominal interest differential and exchange rate changes.

It is also possible that capital movements to take advantage of interest rate differentials can be driving exchange rates in the opposite direction to that predicted by the IFE. One example of this phenomenon is the carry trade, whose existence also indicates that many investors believe that they can profitably arbitrage interest rate differentials across countries on an unhedged (or ‘‘uncovered’’) basis.

Application

The Carry Trade

Thecarry tradeinvolves borrowing a currency bearing a low interest rate and investing the proceeds in a currency bearing a high interest rate. In recent years, the carry trade has centered around borrowing yen in Japan at rates close to zero and selling the yen to invest in higher-yielding assets, such as U.S. Treasury notes or European bonds. By 2007, it was estimated that the yen carry trade totaled about $1 trillion.

According to the international Fisher effect, carry trades should not yield a predictable profit because the interest rate differential between two currencies should (aside from currency risk considerations) equal the rate at which investors expect the low interest rate currency to appreciate against the high interest rate one. However, the existence of a large volume of carry trades may lead to an opposite result. For example, as borrowed yen are sold to buy dollars, carry trades will send the yen lower and boost the dollar.

The danger, of course, is that the small, steady returns from the carry trade (say, borrowing at 1%

in yen and investing at 5% in dollars to earn a spread of 4%) is the possibility of a very large, very sudden loss when the dollar sinks or the yen jumps in value. The currency effect will be exacerbated if speculators try to cut their losses by bailing out of their dollar assets and repaying their yen debts. This risk is captured in the colorful description of the carry trade as ‘‘picking up nickels in front of a steamroller.’’

A good example of this occurred in 2007 when the Federal Reserve started slashing short-term interest rates in September. With Japan’s rates remaining unchanged, the yen jumped sharply against the dollar. In response, many carry trade speculators unwound their carry trades, helping to push the yen up further and triggering a global sell-off in assets that had been financed by the yen carry trade.

Application

Iceland’s Economy Heats Up and then Freezes Over

In mid-2007, The Economist explained to its readers that Iceland was defying economic theory by borrowing abroad five times the value of its GDP with no adverse consequences. According toThe Economist(July 21, 2007, p. 72), Icelandic companies and consumers were enjoying apparently risk-free currency arbitrage:

High rates have made Iceland the beneficiary of the ‘‘carry trade,’’ where investors borrow in a low-yielding currency and invest the proceeds in a higher-yielding one. This trade offends economic theorists, who assume the juicy yields Iceland offers will be offset by an eventual plunge in the value of its currency. But so far the trade seems to have worked. Meanwhile, Icelandic consumers have taken the opportunity to borrow cheaply abroad, bypassing the punishing interest rates imposed by the central bank.

The effects of Iceland’s borrowing spree were epic. In the span of three years, Iceland’s per-capita income tripled, and its stock market capitalization (the value of all listed shares outstanding) increased by a factor of eight. Then financial gravity struck in the form of the global financial crisis. By October 2008, when the full force of the crisis hit, Iceland’s currency (the krona) depreciated against the euro by

85%, its stock market capitalization plummeted by over 90%, and all three of its major commercial banks went bankrupt. Relative to the size of its economy, Iceland’s banking collapse was the largest suffered by any country in economic history. Iceland had no recourse but to seek financing from the IMF. Although the full cost of the crisis is still unknown, it is estimated to exceed 75% of the country’s 2007 GDP.

The Economist’sinstinct that there is no such thing as a free lunch, including in international financial markets, was borne out with a vengeance. Perhaps it will better trust economic theory in the future.