Major disruptions in global politics and economics will disrupt financial markets. 9/11, the Greek Crisis and the recent Brexit all being good cases. How do these events impact interest rate expectations and therefore IRP between major currencies?
Significant disruptions in economics and global politics significantly disrupt the financial markets. Good cases of such disruptions include 9/11, the Greek crisis, and the recent Brexit. Such disruptions usually cause instability and uncertainties in the financial markets due to the slowed economy and adverse effects on business. As a result, most investors are unwilling to invest because of the fear of incurring losses or low returns on their investment. During such times, Central Banks initiate appropriate measures and interventions meant to stimulate the economy and avoid a further financial crisis. One of the critical interventions taken includes cutting interest rates to encourage consumer spending and stabilize the economy (Gehringer & Mayer, 2019). Therefore, interest rates are usually expected to fall during periods of severe economic and political disruptions. With this, commercial banks and other financial institutions slash their lending rates. However, a fall in interest rates has a significant impact on financial markets. For instance, low-interest rates result in reduced profits for financial institutions such as banks. It also affects investors in the financial markets, as their savings attract low returns.
The expectations of a fall in interest rates have an impact on IRP between major currencies. The basic principle of IRP holds that the returns acquired from investing in different currencies should be equal irrespective of the interest rates levels (Perera et al., 2018). However, fluctuations in interest rates caused by economic or political disruptions may affect currency exchange rates due to uncertainties on investment returns. For instance, expectations of lower interest rates may result in increased fear of investment in the affected country, thus leading to a decline in the country’s currency value. Consequently, fluctuations in the currency exchange rates of the key players in the global financial market impact the IRP between major currencies. Fluctuations in the value of major currencies creates imbalances in returns when investing using different currencies.
When consumer and investor economic expectations are grim during events like 9/11, Brexit and the Greek Crisis, a decline in that country’s interest rates typically occurs followed by relatively high inflation. Forward rates are effected as a result. In situations where foreign interest rates are higher than the home country, forward rates experience a discount. The level of this discount should be proportional to the degree of differential in interest rates between the two countries in question according to the interest rate parity. This can also cause short-run combined interest arbitrage benefits until IRP occurs through forward rate adjustments. However, investor concerns about repayment feasibility due to political risk may prevent some from participating in the volatile financial market which further drives interest rates downward. A reduction in interest rates causes pressure in forward discounts downward to the same degree. Lower interest rates and inflation cause a decrease in imports and increase in exports as demand for the currency rises. This eventually leads to an appreciation in the currency value relative to level of inflation differential with trading countries according to the IFE.
Major disruptive events in global politics such as9/11, the Greek Crisis andBrexit have generally led to interest rate cuts. By lowering interest rate, the government aims to encourage borrowing and spending, stimulate recovery from the current downturn and prevent the economy from plunging into further recession.
Based on the IRP theory, in order to eliminate any opportunity of covered interest arbitrage, exchange rate has to adjust according to offset the interest rate differential across currencies. With interest rate lowered in the home country, the forward rate of the foreign currency necessarily experiences a discount. The forward rate differential ought to be equal to the interest rate differential for the market to return to its original state of equilibrium. If not, investors can easily take advantage of the higher foreign interest rate with a forward contract to engage in covered interest arbitrage.