Currencies of countries with high inflation rates tend to always have forward discounts. Nominal interest rates reflect the investors’ expectation about future inflation. Spot exchange rates are influenced by the transactions demand of money while the forward exchange rate is influenced by speculative factors like the expected future inflation rate and expected return from holding domestic and foreign bonds. Forward discount is a situation that the domestic spot exchange rate is trading at a higher level than the current domestic futures spot rate for a maturity period and it’s an indication that the current domestic currency exchange rate will depreciate in the value against other currencies in the future. This is because countries with high inflation rate will have high interest rates which will make the currency of that particular country depreciate compared to currencies of countries with lower interest rates hence the existence of a forward discount (Madura, 2008).
International fisher effect (IFE) is an economic theory that states that the expected change in the current exchange rate between two currencies is equivalent to the difference between the two countries’ nominal interest rates. It was developed by Irving Fisher and it’s based on the present and future risk-free nominal interest rates and not the inflation. The model predicts present and future spot exchange rate movements. According to the IFE line, points below the line indicate higher returns for a country which invests in foreign treasury bills where the foreign interest rates is high than the domestic interest rates. Combination of a higher foreign interest rate and appreciation of the foreign currency makes the yields from investing in foreign treasury bills to be higher than would be domestically. The foreign investments in the treasury bills will cause the interest rates in the foreign country to rise which would lead to appreciation of the currency. Points which are below the IFE line reflect lower foreign returns on investments than would be possible if investments were done domestically. There are two scenarios which can result in low returns like when the foreign interest rates are low than domestic interest rates or when the foreign currency depreciates which makes the investor receive lower return than would be possible if investments where made on domestic treasury bills. This investment strategy will not generate high returns from foreign treasury bills because the exchange rate decline will almost offset the interest rate differential. For instance, if country A has an interest rate of ten percent and country B an interest rate five percent then country B’s country will appreciate almost five percent compared to country A’s currency which eliminates the interest differential gains of investing in foreign treasury bills where the interest rates are high (Madura, 2008).
Madura, J. (2008). International financial management. Mason. Thomson Higher Learning.