(a) Derive and explain the following and discuss whether they hold in practice:

The Fisher effect

The Fisher Effect is a financial and economic theory that describes the relationship between
nominal interest rates, real interest rates, and expected inflation rates. It was named after
the American economist Irving Fisher, who proposed the concept in the early 20th century.
The Fisher Effect suggests that changes in nominal interest rates are directly related to
changes in expected inflation rates, while real interest rates (interest rates adjusted for
inflation) remain relatively constant.

The Fisher Effect is the economic theory that states that nominal interest rates adjust in
response to changes in expected inflation rates, with the relationship expressed as:

Nominal Interest Rate = Real Interest Rate + Expected Inflation Rate

The Fisher Effect posits that, in the long run, nominal interest rates will adjust to changes in
expected inflation rates, keeping the real interest rate relatively stable. The theory implies
the following relationships if expected inflation increases, nominal interest rates will also
rise to compensate lenders for the anticipated loss of purchasing power.Conversely, if
expected inflation decreases, nominal interest rates will fall because there is less need to
protect against rising prices.

While the Fisher Effect provides valuable insights, it is important to recognize that it
assumes rational expectations and long-run equilibrium conditions. In the short term,
interest rates can be influenced by a wide range of factors, including central bank policies,
economic shocks, and market sentiment, which may lead to deviations from the Fisher
Effect.

The International Fisher Effect (IFE)

The International Fisher Effect posits that, in the absence of any risks or transaction costs,
the difference in nominal interest rates between two countries should be equal to the
expected change in the exchange rate of their currencies over a specified period. In other
words, it asserts that differences in nominal interest rates are primarily influenced by
differences in expected inflation rates between two countries.

The International Fisher Effect argues that if two countries have different nominal interest
rates (for the same maturity) and are in the absence of any risks or costs associated with
currency exchange, then the country with the higher nominal interest rate will also have a
higher expected inflation rate. This is because investors will demand compensation for the
erosion of their purchasing power due to inflation.

In summary, the IFE suggests the following relationships:

 If Country A has a higher nominal interest rate than Country B, then Country A is
expected to have a higher inflation rate than Country B.
 If Country A has a lower nominal interest rate than Country B, then Country A is
expected to have a lower inflation rate than Country B.
Derivation of International fisher effect
Home country =1+I Overseas country= ( St1 ) ¿
According to IFE,
(1+i)=(1/st)(1+i*).E(St+1)
E ( St +1 ) 1+ i
=
St 1+i∗¿ ¿
Deduct each side by 1
E ( St +1 ) 1+ i
−1=
St 1+ i∗¿−1¿
E ( St +1 )−St i∗¿
=1+i−1− ¿
St 1+i∗¿ ¿
E ( St +1 )−St i∗¿
=i− ¿
St 1+i∗¿ ¿
i∗¿
E( △ St ¿ = i− ¿
1+i∗¿ ¿
If i*=0
E ( △ St ¿ =i-i*
If i*=0(close to 0), 1+i*=1
E( △ St ¿ =i-i*, what you lose in interest rates=gain in exchange rates

It's important to note that the International Fisher Effect provides a simplified framework
and makes certain assumptions, such as the absence of risks or transaction costs. In reality,
various factors, including risk and transaction costs, can influence nominal interest rates and
exchange rates. Nonetheless, the IFE remains a valuable concept for understanding the
potential link between interest rates, inflation, and exchange rate movements in
international finance.

The Interest Rate Parity Theorem (IRPT)

Interest Parity Theory posits that in a world without transaction costs or restrictions on
capital movements, the difference in interest rates between two countries should be equal
to the percentage difference between the current spot exchange rate and the forward
exchange rate for the same future date.

The Interest Parity Theory makes the following propositions:

- If the interest rate in Country A is higher than in Country B, investors will demand higher
returns to hold Country B's currency. As a result, the spot exchange rate of Country B's
currency should depreciate against Country A's currency to provide the required return.
- If the interest rate in Country A is lower than in Country B, investors will find it less
attractive to hold Country A's currency. Therefore, the spot exchange rate of Country A's
currency should appreciate against Country B's currency to provide a higher return.

Derivation of interest rate parity theorem (IRPT)

Home=1+i Overseas country=¿
1+i=¿

( )
Ft
St
=
1+ i
1+i∗¿¿
Subtract both side by 1
Ft 1+i
−1=
St 1+i∗¿−1¿
Ft −St i∗¿
=1+i−1− ¿
St 1+i∗¿ ¿
Ft −St i∗¿
=i− ¿
St 1+i∗¿ ¿
If i*=0, 1+i*=1
Ft −St
=i−i∗¿
St
Annualised fund premium or discount= ( FtSt )∗( 365n days
days
)∗100
In essence, the theory suggests that the forward exchange rate should reflect the
anticipated future spot rate, accounting for the interest rate differential between two
currencies. If there is a deviation from interest parity, arbitrage opportunities arise, where
investors can profit by borrowing in one currency, investing in another with a higher interest
rate, and then exchanging back at the forward rate.

Interest Parity Theory is essential for understanding how interest rates, exchange rates, and
capital flows interact in the foreign exchange market. However, it's important to note that
real-world currency markets are affected by various factors, including transaction costs, risk,
and government interventions, which may lead to deviations from interest parity.
Nonetheless, the theory provides valuable insights into the relationship between interest
rates and exchange rates.

Difference between international fisher effect and Interest rates parity theory?
1. Focus and Purpose:
The IFE primarily focuses on the relationship between nominal interest rates, real interest
rates, expected inflation rates, and their impact on exchange rates. It aims to explain how
differences in nominal interest rates between two countries are reflected in expected
changes in exchange rates. The IFE helps investors and analysts understand how interest
rate differentials influence international investments. IRP, on the other hand, focuses on the
relationship between nominal interest rates, spot exchange rates, and forward exchange
rates. Its primary purpose is to ensure that there are no arbitrage opportunities in the
foreign exchange market. IRP helps determine the relationship between interest rate
differentials and forward premiums or discounts on currencies.
2. Variables Involved
The key variables in the IFE include nominal interest rates, real interest rates, and expected
inflation rates in two different countries. The IFE equation relates these variables to
expected changes in exchange rates. While IRP involves nominal interest rates, spot
exchange rates, and forward exchange rates. The theory aims to establish a relationship
between these variables to prevent risk-free arbitrage opportunities.
3. Objective:
The IFE primarily helps investors and analysts predict how exchange rates might change in
response to differences in nominal interest rates and expected inflation between two
countries. It focuses on the direction of exchange rate movements. The IRP's main objective
is to ensure that the relationship between interest rates and forward exchange rates is
consistent and free of arbitrage opportunities. It emphasizes the absence of risk-free profit
opportunities in the foreign exchange market.
4. Arbitrage Implications:
The IFE does not directly address arbitrage opportunities but rather helps investors
understand how interest rate differentials affect exchange rate expectations. It does not
provide a mechanism to exploit arbitrage opportunities. While IRP explicitly addresses
arbitrage opportunities. If interest rate differentials are inconsistent with forward premiums
or discounts, traders can engage in arbitrage to profit from the discrepancies. IRP ensures
that such opportunities are short-lived and quickly eliminated.

(ii) Under what condition is there no difference between IFE and IRPT? (5 marks)
The International Fisher Effect (IFE) and the Interest Rate Parity Theory (IRPT) are related
concepts, but there are conditions under which they converge or have no difference.
Specifically, there is no difference between IFE and IRPT when the following condition holds:

IFE and IRPT will yield the same results when the real interest rates (i.e., nominal interest
rates adjusted for inflation) are equal between two countries. In other words, if the real
interest rate in Country A is the same as the real interest rate in Country B, then IFE and
IRPT will produce equivalent predictions regarding exchange rate changes.

Under this condition of equal real interest rates, the impact of inflation expectations on
nominal interest rates cancels out, leading to parallel shifts in nominal interest rate
differentials in both IFE and IRPT equations.

This equality in real interest rates ensures that the interest rate differentials between the
two countries are solely driven by nominal interest rates, and both IFE and IRPT focus on
these nominal interest rate differences. Therefore, when real interest rates are equal, there
is no distinction between the two theories, and they provide consistent predictions
regarding the relationship between interest rates and exchange rates.

In summary, the condition under which there is no difference between IFE and IRPT is when
real interest rates are equal between two countries. This equality eliminates the impact of
inflation expectations on nominal interest rates, leading to equivalent results in both
theories.

The Unbiased Forward Rate Theory

Unbiased Forward Rate Theory, also known as the Unbiased Expectations Theory, is a
financial concept in the field of international finance and economics. This theory relates to
the pricing of forward exchange rates in the foreign exchange market. It suggests that the
current forward exchange rate for a currency should be equal to the future expected spot
exchange rate, adjusted for any interest rate differentials between two currencies. In essence,
it posits that the forward rate should be an unbiased predictor of the future spot rate.

Unbiased Forward Rate Theory asserts that the forward exchange rate for a currency should
reflect the market's expectations of the future spot exchange rate for that currency. In other
words, it implies that the forward rate should not be biased in any particular direction neither
overestimate nor underestimate the future spot rate.
E(St+1) =Ft
Subtract and divide by St on both side:
E ( St +1 )−St Ft−St
=
St St
E(%St)=forward premium/discount

Here's the logic behind the theory:

- If the forward rate overestimates the future spot rate, it would suggest that the currency will
appreciate more than expected. In this case, investors would have an incentive to sell the
currency forward, causing its value to decrease in the spot market to align with expectations.
- If the forward rate underestimates the future spot rate, it would suggest that the currency
will appreciate less than expected. Investors would then have an incentive to buy the currency
forward, driving up its value in the spot market.

The idea is that any potential biases in the forward rate would create arbitrage opportunities
in the foreign exchange market, which rational investors would exploit to ensure that the
forward rate aligns with their expectations of the future spot rate.

Unbiased Forward Rate Theory is essential in understanding how forward exchange rates are
determined and how they reflect market participants' collective expectations about future
currency values. However, it's important to note that real-world currency markets are
influenced by various factors beyond interest rate differentials, such as economic data,
geopolitical events, and market sentiment, which can lead to deviations from the theory.
Nonetheless, it serves as a foundational concept in international finance.