Chapter 21, Part II. The Power of Interest Rates. Page 7

Commander in Pips: May be, but there are two important issues that appear:

- There is not only interest rates among factors that could influence on the future exchange rate.

- that’s why it is better to choose pairs with greater interest rate difference, say, AUD/JPY if you want to hold position for a long time, since greater interest rate difference (if it will not change, of course) will better compensate for negative surprises from other factors.

Pipruit: I have to remember that.​

Commander in Pips: Also there is such term as “real interest rates”. This is very simple – this is just the interest rate adjusted for inflation:

Real interest rate = nominal interest rate – annual inflation​

Some traders think that applying of that formula will give you fairer assessment of rate differential. And they are right. Since a nominal rate could be 25 %, but with inflation of about 20% it will give you just a 5% real yield!

Pipruit: Well, but it could lead to negative interest rate!​

Commander in Pips: Yes, in fact it could.

Pipruit: And how to deal with that?​

Commander in Pips: Absolutely the same way as with positive rate. And the last thing to note here… For estimation of future rate based on interest rate differential you do not have to use the 1-day rates that appointed by Central Banks. If you intend to invest in currency pair for, say, 2-years, you may use as a rate the yield of 2-year government bonds, for 5-years – 5-year bonds, and so on:

For instance, 2-year US note yield is 0.2%, while UK 2-year yield is 0.6%. Current GBP/USD rate is 1.65. Hence fair ratio for 2-year investment, if nothing will change, based on rate differential:

1.65*((1+0.006)/(1+0.002))^2 = 1.6632 ​

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P.S. This lesson was written by Sive Morten, who has been working for a large European Bank since April of 2000, and is currently a supervisor of the bank's risk assessment department. Sive's knowledge of forex market and banking industry is vast and quite complete. If you have any specific questions about forex, banking industry, or any other financial instruments, please post them on the next page and Sive should answer soon.



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