International Fisher Effect
This theory predicts that the spot foreign exchange (FX) rate will change over time to reflect and offset differences in interest rates in the respective currencies.
So for example, unhedged currency depreciation losses will on average negate and match exactly any gains on interest differentials between the two currencies.
The International Fisher Effect links Expectations Theory in FX markets with Interest Rate Parity.
Interest rate parity theory predicts that forward FX rates will reflect interest rate differentials.
Expectations Theory predicts that forward FX rates will be reflected - on average - by outturn spot FX rates for the same maturities.
One way of speculating about this relationship is an FX carry trade. The trader speculates that the spot exchange rate will not change by as much as predicted by the International Fisher Effect.
Among other things, the International Fisher Effect suggests that it should not be possible to earn consistent profits by entering such FX carry trade speculations.
This is because of no-arbitrage theory, which suggests that it should not be possible to earn consistent speculative profits by speculating against Expectations Theory in any market.
- Example: Emerging market currency - carry trade
- A trader borrows a hard currency at an interest rate payable of 1% per annum.
- They invest in an emerging market currency to enjoy an interest rate receivable of 10% per annum.
- So long as there is no change in the exchange rate between the two currencies, the trader enjoys a gain of (approximately) 10% - 1% = 9% per annum, for as long as the carry trade is open. Usually measured in days.
- However, the International Fisher Effect predicts that the emerging market currency will weaken against the hard currency, resulting in an offsetting exchange loss for the trader (who is holding the - now weaker - emerging market currency). By an average amount that can be calculated from the interest rate differential.
- If that didn't happen, then everyone in the market would be making such trades and earning consistent profits. Which doesn't appear to be happening in practice.