Correlation between interest rates and currency exchange rates

Singapore Interbank Offered Rate (SIBOR) hit a 17-month low of 2.75% yesterday. (The Straits Times, 18 April 2007, written by Erica Tay). In her concluding remark, she mentioned that interest rates in many Asian economies have been falling on expectations of their currencies appreciating against US dollars and the Euro. Is there a negative correlation between interest rate of a country and the currency of the same country?

The theoretical underpinning is that capital moves internationally in response to asset yield differentials of countries, taking into account anticipated exchange rate movements. Interest rates in a country with depreciating currency have to be sufficiently high to compensate asset holders for the depreciation of assets in that country. (Reference- Macroeconomics by Rudiger Dornbusch and Stanley Fischer, 6th Edition)

This explains the negative correlation.

With perfect information for the investors and no deliberate intervention by the central banks and the governments, the above theory holds true. The exchange rates of cross-currencies will find their equilibrium ultimately with investors moving capital funds round the various economies in search of high yielding investment assets. We are making assumption that there is no foreign exchange controls imposed by the countries for this to happen.

Read also Financial Tip #31 on “Interest Rates Drive the Financial Markets”.

Written on 4/18/2007 3:09 PM

Copyright © 2007, the author known as LKT in Singapore.

The material presented is intended to be general and written in layman’s language as much as it is possible. The author shall not be liable for any direct or consequential loss arising from any use of material written. Please seek professional advice from your financial advisor or financial institutions on material written covering financial matters.

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