Question

When International Fisher Effect (IFE) does not hold

Select one:

a. the financial markets are in equilibrium.

b. there are opportunities for covered interest arbitrage.

c. there are opportunities for uncovered interest arbitrage.

d. there is usually a low degree of inflation in both countries.

Answer 1

Understanding International Fisher Effect (IFE): IFE is a theory that strives to correlate the exchange rates and interest rates of two countries. It states that the expected differential between the exchange rate of 2 currencies is approximately equal to the differential between their countries nominal interest rates, balancing both out in terms of Real Rates. i.e. the currency with a higher interest rate will have a currency that is more depreciated against the other currency (due to higher inflation) and the other country (with stronger currency) will have lower interest rate.

Formula for IFE: E = [(i₁-i₂) / (1+ i₂)] _͌  (i₁-i₂)

Where:

• E = Percentage change in the exchange rate of the country’s currency (the one you're trying to calculate)
• I₁ = Country’s A’s Interest rate (nominal)
• I₂ = Country’s B’s Interest rate (nominal)

When does IFE not hold?

Answer - d. There is usually a low degree of inflation in both countries.

Reason: IFE is based on the assumption that the inflation in one of the 2 countries will be higher, leading to a devaluation of the currency which is offset by a higher interest rate.