Exchange rate and unanticipated shocks to nominal interest rates

Abstract

Whenever there is a change in interest rate at either home or foreign country then the exchange rate should change such that UIP (Uncovered interest rate parity) condition holds at every point in time. For example “Returns for borrowing in terms foreign currency, exchanged against home currency in the market and then invested in interest-giving instruments, while at the same time purchasing futures to turn the currency back to the original when holding period gets over, must be equal to the returns from buying and holding the same interest-giving instruments denominated in terms of national currency. If those returns are different then a risk-free return exists by arbitrage [11] ”. Higher interest rates strengthen the country’s currency w.r.t. to other low interest rate countries, ceteris paribus. Higher interest rate (I.R.) attracts foreign investment and increase demand for as well as value of home country’s currency. [1] This simple relation becomes complex due to various other factors that affect exchange rate. Expectations of national interest rate may differ from the actual prescribed rate by Monetary policy committee (MPC) in their Bi-monthly Monetary Policy Statement. This study quantifies the market’s expectation of interest rate for time period before the MPC meeting. The difference between expected interest rate and actual interest rate announced is the unexpected shock that market experiences. This shock creates an unexpected change in the relationship between I.R. and exchange rate (E.R.). This research looks at the quantification of expected interest rate by collecting data from various public sources, market research data and media reports. The difference in interest rates is mapped with corresponding change in the E.R. on the day of announcement of national interest rate by MPC. This study was an attempt to study the relationship between exchange rate and size of unexpected shock in interest rate announced and expected. When MPC announced an interest rate which was not in line with ongoing expectations, we observed an unexpected change in E.R. and currency value. The direction of change of E.R. was in line with the theory. Whenever news sources were expecting a rate cut and it didn’t happen, we observed an decrease in exchange rate and vice versa. The magnitude of change in exchange rate was not proportional to the size shock that market got in terms of deviation from expected interest rates.