Aren't interest rates supposed to converge to a particular point, through arbitrage? Why then do we not see that happening in the real world?
I asked my professor why this doesn't happen, and he said exchange rate movements between currencies make sure that capital gains from interest rate differentials are nullified. I am not sure if it works that way.
To take an example, lets say in January 1997, the interest rate in both the US and the UK is 20%, and the exchange rate between the currencies is £1 = $2. If an Englishman wants to invest £100 in the US, he'd have his £100 converted into $200, invest it in the US and gain 20% interest, then convert his increased dollar stock ($240) to pounds, and still notice that he'd have a gain of 20% interest on his pound stock (which now when converted back to pounds would be £120). Now lets take another case where in January 2000, say the UK cuts its interest rate down to 10%, and the exchange rate adjusts to say, £1 = $1.5. Certainly the englishman now would be able to acquire lesser amount of dollars ($150) with 100 pounds, BUT he will still have the incentive to move his capital to the United States since at maturity he'd earn $180, which when converted to pounds would yield £120, while on the other hand, if he had invested his £100 in the UK, he would have got a return of only £110. So capital would still move to the US, irrespective of changes in the exchange rate, no?
Short answer: One country may have to pay higher interest rates because investment there is percieved as riskier, and/or has higher inflation.
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Dave, can you point out what's wrong in the example I've used? I want to know what I'm missing.
Interest rates are set by the central banks and from what I understand are not set based on exchange rate considerations.
I found the answer to the question. Exchange rate forward contract rates would fluctuate to cancel out the gain that could be had from interest rate differentials between two countries. Also, if one is to argue that interest rate differential gain could be had if one doesn't go into a forward contract, the differential between interest rates could be attributed to the risk associated with investing money without undergoing a forward contract.
In your example, replace "USA" with "Greece".