Question

The Federal Reserve recently announced that it will keep US interest rates low for a longer period of time than previously announced. Using interest arbitrage, explain the effect that this announcement is likely to have on spot and forward exchange rates.

Answer 1

The Federal Reserve recently announced that it will keep US interest rates low for a longer period of time than previously announced.The central banks of the country set the target interest rates which the public and commercial banks follow in the country in their lending transactions. This is done to bring about stability in the financial system of the country and help execute government policies. Thus if the Fed (Central Bank) follows a low interest rate , the commercial banks will follow suit.

Interest Rate Arbitage: Interest rates differ amongst countries based on their current trade cycle, which creates a prospect for investors. By purchasing foreign currency with a domestic currency, investors can earn profit from the difference between the two countries interest rates. Arbitrage in investments means investing strategy that exploits the market inefficiencies to trade which is almost risk-free.

Effect of this decision:

• Spot exchange Rates: The spot rate is the current price quoted for immediate settlement of the contract. If the interest rate in a country is low its currency is considered less valued, so its demand in the foreign exchange markets falls. If we speak in terms of interest rate arbitrage the earnings for investors from this currency will be low thus there will be depreciation and its exchange power will be weak.
• Forward Exchange Rates: It is the exchange rate at which a bank agrees to exchange one currency for another at a future date while arriving into a forward contract with an investor. Taking into account the fact that the Fed plans to keep the interest rates low for a longer period we can say that the earnings for investors from interest rate arbitrage will be low while doing forward transactions .