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Do Higher Interest Rates Make US Dollar Stronger?

The higher the US interest rates, the higher the demand for US Dollar is. So, would Dollar become stronger after the Fed raises rates?

Based on the no-arbitrage pricing model for exchange rates, Dollar may not always become stronger with higher interest rates.

No-Arbitrage Pricing Model for Exchange Rates

Arbitrage means making a profit without any risks. No-arbitrage pricing means when there is any arbitrage opportunity, there will be enough arbitrage trading that change the underlying assets' values to to the points where there is no arbitrage opportunity left.

The no-arbitrage pricing model is applicable for exchange rates and is also called the interest rate parity.

Example

Suppose US dollar's interest rate is 1%, euro 's interest rate is 0%, the spot exchange rate is 1EUR/USD and the 1-year forward exchange rate is 1 EUR/USD , too.

We can simultaneously borrow 100 euros, buy 100 dollars, which is saved in a bank for 1 year and sell 100 dollars for 100 euros in an 1-year forward contract.

In 1 year, we earn a 1 dollar interest and we sell 100 dollars for 100 euros for repayment while there are no cost, no principal and no risks. This process is called arbitrage.

More and More People See This Arbitrage Opportunity

When people start seeing this arbitrage opportunity, they will start the arbitrage trading of borrowing euros, exchanging it for dollars, saving dollars in a bank, and sell 1-year dollar-to-euro forward contracts.

During this process, Dollar forward should become weaker until it can only be exchanged to the initial borrowed amount of euros so that there is no profit at all.

As referring to the previous example, the 1-year dollar-to-euro contract should drop to 1 / 1.01 = 0.99 USD/EUR. Here, this 1.01 is 1 plus the dollar interest rate of 1%.

The whole case has become borrowing 100 euros, buying 100 dollars, saving it in the bank to get 101 dollars in 1 year, and sell 101 dollars for 100 euros for repayment, which doesn't generate any profit.

What Happened During the Last Rate Hikes?

Dollar had become stronger before 2015. During rate hikes from 2015 to 2019, US Dollar index fluctuated.

Conclusion

The no-arbitrage pricing model suggests that the currency with a higher interest rate would have a cheaper forward price.

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