Another example will help explain the behavior of prices in the government bond market (and other forms of bond markets). Again, it will be easier if we take a fictitious example than if we take real securities. Suppose that in 1999 the government decided to issue three different bonds. One of them was short-term with a maturity of 3 years, the other was medium-term with a maturity of 10 years, and the third was long-term with a maturity of 25 years. Let's also assume that the government believes, given the structure of interest rates at that time, to offer investors a yield to maturity of 4. 5% on each of the bonds in order to entice investors to buy them (we took these figures for convenience and not as an indication of the exact interest rates at the time) Therefore, each bond is issued with a par value of ?100 with a coupon of 4.5% .
Of course, our assumptions are somewhat unrealistic. It is very unlikely that the returns investors expect will be the same for short-, medium- and long-term bonds. But they serve to illustrate the essence of our explanations. So, we have three bonds, the data for which is presented in table. 13.3.
Table 13 3
When each bond sells for ?100, the current yield and the yield to maturity are exactly the same because at that point they have no gain or loss to maturity for the investor.
Now suppose that a year later the British economy has worsened. There is evidence that higher inflation is on the way, and investors are demanding higher yields to compensate. If the government were to issue a new government bond at this point, it would have to offer a yield of, say, 6% to convince investors to buy it. What will happen to the market prices of our three bonds issued in 1999? The obvious answer is that no investor will buy them at ?100 when the yield to maturity is only 4.5%. Bond market prices will have to fall until they reach a level at which investors would buy them. What will this level be? This is the price at which they will offer the 6% yield to maturity that investors now expect. Once again, we're going a bit far from reality because it's doubtful that investors would expect exactly the same yield to maturity from these three bonds with different maturities and different tax characteristics. But to illustrate our story, the situation will be as shown in table. 13.4, where each bond must now offer a yield to maturity of 6% (recall that the remaining life of each security is now one year shorter than when they were issued in 1999).
This example shows very clearly that long-term bonds exhibit much larger price changes for a given change in interest rates than short-term bonds. An investor in a short-term bond who bought it initially for £100 and now wants to sell it would lose some money, but not much. An investor with an intermediate-term bond would lose quite a lot, and an investor with a long-term bond would lose the most. Investors in all three bonds would eventually get their hundred back if they held the bonds until maturity, but would suffer significant losses in the interim. Thus, investors who are risk averse and might want to get their money back quickly are likely to buy short-term bonds. Those who want to tie up their money for the long term with a known return, along with more risk-averse investors and those who want to make a conscious bet on favorable changes in interest rates, are more likely to move into long-term bonds.
The pressure to repay is much stronger for short-term bonds than for long-term ones. When a bond is due to mature in the near future at par ?100, redemption has the predominant effect and its price will not fluctuate as widely in response to changes in interest rates. As the example shows, they do not need to behave this way in order to adapt to the changing expectations of investors regarding the income they should receive. These days, short-term interest rates can fluctuate widely (perhaps more than long-term yields) and will affect short-term bonds more than long-term bonds. Thus, as our example shows, price fluctuations can be quite noticeable even in the short end of the market. But the risk of capital loss here is still significantly lower than in the long-term bond market. Market reports will often highlight the different magnitudes of price changes in the long-term and short-term segments of the bond market. Investors move their funds between securities with different maturities in accordance with the expected direction of movement of long-term and short-term interest rates.

More on the topic The impact of interest rates:

1. Bond Maturity and Yield: Interest Rate Risk
2. Strategies for managing interest rate risk
3. Study of Aggregate Output and Interest Rates Based on the /SLM Model
4. 2.2. The influence of interest rate policy on the profitability of credit operations
5. 3.1. The concept of interest rate risk, an overview of possible management strategies
6. 3.2. Using GAP analysis when making decisions on interest rate risk management
7. Analysis of the influence of external factors on pricing in commercial banks

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Anyone who follows the market is well aware that one of the most powerful fundamental news affecting the market is news about changes/maintenance of interest rates. But not everyone understands the patterns and consequences of changing rates on the exchange rate. Meanwhile, this is a regularly repeating story, one of the most well-functioning indicators of exchange rate movement. Using examples, I will try to explain what an interest rate differential is and what impact it can have on a currency.

Let us remember that quite recently the European Central Bank (ECB) halved the refinancing rate from 0.5% to 0.25%.

An interesting fact is that, according to analysts, the eurozone now has the lowest rate level in its history. ECB President Mario Draghi explains this decline by saying that the eurozone may face an even greater decline in inflation rates in the future, namely deflation. In general, the eurozone economy is still very weak, so this ECB policy will continue. There were three main reasons for the ECB rate cut:
1) Annual inflation in the eurozone fell from 1.1% in September to 0.7% in October
2) The unemployment rate rose to 12.2%
3) Strengthening of the euro by 5% against other major currencies

Why did the euro rise? The main reason is that the demand for the euro was triggered by cash injections from investors in Japan, the United States and other countries.

Most fundamental factors are related to each other and interest rates are no exception; in order to predict the dynamics of exchange rates for any future, you need to see and be able to read these relationships. In connection with recent events, I would like to take a closer look at what the interest rate differential is and what impact it can have on the currency.

The differential is, first of all, the difference, and in this case it is the difference between the key interest rates of Central banks. Interest rates are the most important tool of monetary policy, for example, if the European Central Bank changes the refinancing rate, as it did, this directly affects the interest rates on loans, deposits and other money market instruments.

So why do interest rates have such a strong impact on the exchange rate? In order to understand this, it is necessary to understand the mechanisms by which a regulator’s decision (for example, the ECB) affects the exchange rate.

Let's imagine that we have savings deposited in a bank, and a neighboring bank located nearby suddenly increased the interest rate. There is no point in staying in our bank - other things being equal - and it is easier for us to open a second account in another bank and transfer money at a higher interest rate.

Institutional and international investors are the same people as you and me, so if one of the Central Banks raises the interest rate, it thereby increases the profitability of money market instruments and provokes a flow of capital from one country to another. How can you transfer to the assets of another country? Answer: very simple, buy them! And you need to buy them for money, and accordingly there is a need to purchase national currency.

So it turns out that an increase in the difference in interest rates leads to an increase in the country’s exchange rate. At the same time, we should not forget about such important macroeconomic indicators as inflation and unemployment levels, because an increase in the consumer price index, as a rule, indicates an increase in prices for goods and services, and accordingly necessitates an increase in the refinancing rate, but this will not promote the growth of investor interest in increasing investments in the economy of such a country.

Inflation distribution

However, even in countries with almost the same level of development, an increase in the difference in interest rates does not always lead to an increase in the exchange rate of the national currency.

For example, during the dawn of an economic crisis, a decrease in the rate difference may lead to an increase in the exchange rate, but the goal of investors will no longer be to increase their funds, but simply to preserve their own capital. A decrease in the desire to take risks will increase the demand for low-yielding currencies, which are characterized by low interest rates from Central banks. But the lower the profitability, the lower the risk.

We could observe a similar situation in 2008, when the development of the mortgage crisis forced investors to switch to US Treasury bonds, known for their reliability, as a result of which the demand for the dollar increased, and the euro exchange rate sharply decreased.

The cost of loans in the European Union countries has been growing over the past three years despite the reduction in the discount rate, so another reduction in rates will not revive the current situation, but may influence foreign investors and thereby weaken the demand for the euro.

4.5.1. Change in interest rate level

As already emphasized above, changing interest rates is one of the main instruments of monetary policy of the Central Bank of the country. A change in a country's main rate entails a corresponding change in other rates. Of course, changes in the discount rate are carried out by the Central Bank not only to influence the exchange rate of the national currency. But you and I, as FOREX participants, are most concerned about this aspect.

What does the change in the main rate by the Central Bank lead to? (Once again we remind you that we are talking about a typical market reaction, but this is not an axiom!)

Raising the rate means strengthening the national currency (Fig. 4.5.1).

The attractiveness of the national currency as a means of investment is increasing. The reason is that an increase in the prime interest rate leads to an increase in interest rates on bank deposits in commercial banks. Firstly, the interested parties are foreign investors. Their money plays a significant role in shaping the exchange rate of the national currency, since the volume of transactions with it can be very significant. In fact, the growth of the national currency is fueled precisely by the fact that it is becoming popular among foreign investors who are ready to buy the currency at an increasingly higher price in anticipation of a high income on deposits. Attracting investor funds is accompanied by a revival of the national economy. Secondly, domestic business circles and individuals are showing interest in holding funds in national currency. The growth of their interest is directly related to the possibility of “withdrawing” funds from active circulation. Accordingly, tying up money should be accompanied by a decrease in domestic business activity while simultaneously reducing inflationary processes. That is, the demand for this national currency actually increases.

Money has a remarkable multiplier effect, i.e. the same money can circulate up to 50 times (as economists have calculated). When the cost of loans increases, money becomes expensive and unattractive. The multiplier effect decreases, and thus the amount of money in circulation actually decreases, i.e., conditionally, the supply of the national currency decreases.

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We must not forget that by raising the main rate, the Central Bank regulates inflation processes in the country. Raising the rate leads to a strengthening of the currency if we are talking about a country where the inflation rate corresponds to a normal economy. Also, the use of the main rate as a means of regulating the exchange rate should not be overly active. If the rate changes frequently, investors will wonder if the country in which they are investing is in trouble. For example, in 1999, the US Federal Reserve raised rates 3 times, which greatly excited investors. And in 2001, investors were worried about a completely different series of events - the Fed cut rates ten (!) times.

A reduction in the rate means a fall in the exchange rate of the national currency (Fig. 4.5.2).

The attractiveness of the national currency as a means of investment is decreasing due to the fall in deposit rates following a decrease in the main interest rate; as a result, the demand for this national currency decreases.

Money becomes cheaper, the multiplier effect increases in circulation, i.e. we call this an increase in the supply of the national currency. Of course, lowering interest rates should lead to the activation of the country’s economy, but a positive effect in the country’s economy will only be noticeable after some time, which will be reflected in macroeconomic indicators.

4.5.2. Using rate change information

Knowing the rate in itself does not give anything. What is important is its change, which occurs in connection with the decisions of national financial institutions. Traders treat the discount rate like all other factors, trading on rumors and facts. For example, if a rumor says that the discount rate will be raised, the corresponding currency will be bought before this fact occurs. True, after the rate increase takes place, it is quite possible that the currency will be sold back or another one similar to it will be sold. An unexpected change in the discount rate will most likely lead to a sharp change in the exchange rate.

Example. The current prime rate of the Central Bank is 4.0%. As an example, we take an abstract currency and an ideal, i.e., unreal market that reacts only to one news - a change in the rate. There was a message saying that at the next meeting of the Central Bank the issue of changing the rate upward to 4.25% would be considered. This rumor will immediately increase demand, because it is profitable to buy currency while the rate is still low and demand for it has not yet increased. As demand increases, the price will rise. Further, the market will either consolidate or will grow until the start of the bank meeting. Consideration of the issue does not yet mean making a decision, so the following options are possible.

1. The rate increased, as expected, by exactly 0.25% - the market has already “priced itself” on this information, i.e. there is no longer any potential for changing the rate - consolidation is underway.
2. The rate has not increased - the market will return to the level from which it came, i.e. the rate falls (returns).
3. The rate has increased by more than 0.25 - in connection with this unexpected news, the price of the currency will increase very sharply.

Options for changing the interest rate (without taking into account other factors) are presented in Fig. 4.5.3.

It must be taken into account that very serious economic processes are behind the change in the main rate, so the option “the rate was expected to increase, but the rate was reduced” is not considered, and the third option is also unlikely.

Attention! The rates that are the main ones for determining the direction of price movement are highlighted in table. 4.5.1 in bold.

Note 1: On June 30, 2004, the FedFunds rate was increased by the US Federal Reserve by +0.25% to 1.25%.

Note 2: ODR rates may have different names in different countries:

USA, Japan – Discount Rate;
Switzerland – 3 month LIBOR Range;
Australia – Cash Rate;
New Zealand – Official cash rate;
UK – Base Rate;
Canada - Bank Rate.

Examples of the impact of interest rates on exchange rates

Example 1. 02/06/2003, GBP. At 12:05 the news came out: “UK: Bank of England lowered policy rate by 25 basis points from 4.00% to 3.75%.” In the middle of the chart there is a large black candle with high = 1.6471 and low = 1.6375. The situation was like this: the market was waiting for the results of the meeting of the Board of the Bank of England. An unexpected event occurred at the meeting - the rate was reduced by 0.25% to 3.75%. This was the lowest level over the past 48 years, since 1955. The reasons for the bank's decision were low economic growth in the UK and the expectation of a fall in consumer demand at home and abroad (Figure 4.5.4).

Example 2. 06/05/2003, GBP. At 12:00 the news came out: “The Bank of England left the Repo Rate unchanged at 3.75%.” It was expected that the rate would be reduced to 3.50% (Figure 4.5.5).

Example 3. 06/05/2003, EUR – atypical market reaction (Fig. 4.5.6). This example confirms the fact that many factors operate simultaneously in the market and classic chains of events cannot be guaranteed.

At 08:02 a message was issued: “The ECB's interest rate cut is unlikely to open EUR/USD up, given the ongoing sales of EUR/JPY by Japanese investors. This is also not helped by optimism about the American economy.”

At 11:34 the news says: “Most economists think the ECB will cut interest rates by 50 points to 2.0%.”

At 11:45 the news came out: “ECB: interest rates reduced by 50 points to 2% (prev. unchanged, 2.5%).”

The rise of the euro, despite the ECB rate cut, meant that the market began to pay attention to the weak US economy. Traders are cautious about the USD ahead of the release of data on the US labor market, expecting an increase in the number of layoffs to 25,000 people and the unemployment rate to 6.1% from the current 6%. Lara Rhame of Brown Brothers Harriman says: "We are in a positive environment for the euro and I don't think that will change." In addition, the exchange rate of the single European currency was supported by a significant increase in the pound/dollar exchange rate and positive economic data published that day in Germany.

The market reacts not only to changes in current rates, but also very sensitively perceives all the nuances associated with the assessment of the economic situation and changes in the interest rate policy of the Central Bank.

Example 4. 01/29/2004 On January 27-28, 2004, a meeting of the Federal Reserve took place, which, as expected, did not change rates, leaving them at the same level - 1%. However, after yesterday's change in tone from the Federal Reserve, which replaced the phrase "a long period of low rates" with "the need for patience before raising rates", many investors began to revise their estimates for the dollar. Hints that the US may enter a rate hike phase add to the dollar's appeal as the US economy remains the world's largest and is showing signs of healthy growth. And although the problem of huge foreign trade and budget deficits has not been resolved, investors are ready to invest their capital in the American economy if the return on investment in American assets increases. It was these thoughts that caused a sharp fall in European currencies against the dollar yesterday at the end of the American session (Figure 4.5.7).

Example 5. “From Forex Club analytics” for 06/30/2004 - in connection with the decision of the US Federal Reserve to increase the FedFunds interest rate by +0.25% to the level of 1.25%. The greatest impact on the behavior of exchange rates today came from the Federal Reserve's meeting on interest rates. The dollar's attempts to strengthen against its main European competitors during the Asian session led to nothing, and the main trend of the day, long before the announcement of the decision, was the fall of the dollar. The market was expecting a 25 basis point rate hike. This decision was widely expected by the market and did not support the dollar. And since Fed representatives did not try to make additional hints regarding rates, most players preferred to close long dollar positions. The Fed met investors' expectations, which, indeed, was not unexpected for the markets. According to Forex Club dealers, the outcome of the event was expressed only in a surge of activity during the announcement of bets. The exchange rates of the main currencies remained at the same level.

4.5.4. Interest differential and SWAP

Traders react not just to a change in the discount rate as such, but to a change in the difference in discount rates, the interest differential. For example, if all the Big Five countries (US/USD, UK/GBP, Switzerland/CHF, Japan/JPY and EU/EUR) decide to simultaneously cut their interest rates by 0.5%, the foreign exchange market will be indifferent to this because the interest differential will remain unchanged. In practice, in most cases, rates change unilaterally, leading to changes in both the interest differential and the exchange rate.

The generally accepted global practice of carrying out arbitrage operations in the FOREX market requires the mandatory closure of current currency positions opened at a given value date (value date – currency delivery date). Otherwise, for this currency position, real funds must be delivered to the client’s account and to the bank’s account in the amount provided for by the terms of the transaction.

For example: a purchase of 100,000 USD/JPY was made at the rate of 107.42 with a value date of December 8, 2003.

BUY 0.1 USD/JPY at 107.42 (long position)
+ 100,000 USD
-10,742,000 JPY

If the position is not closed intraday, the following movement of funds should occur:

Bank account –> Trader account 100,000 USD
Trader account –> Bank account 10,742,000 JPY

However, traders carry out operations on the FOREX market in order to earn profits from exchange rate differences, and not in order to receive foreign currency in the specified volumes. In this regard, there is a need to transfer an open currency position from one value date to the next.

The operation to transfer a position is called SWAP TOM/NEXT (swap). Its essence is that if at the end of the day (21:00 GMT) the trader has not closed a position, two reverse transactions are simultaneously concluded, of which the first closes the existing position on a given date, and the second simultaneously opens a position in the same pair of currencies with the same volume for the next date. When a position is rolled over, small amounts, expressed in swap points, are typically charged or credited. In fact, this difference reflects the interest rate differential of the currencies included in the trading pair. If you bought a currency for which the discount rate is higher, you will receive a positive swap difference, if you sold it, you will receive a negative one. In our example, the swap difference will be positive, since the rate on USD is 1%, and on JPY – 0.1% (the swap difference is shown in Table 4.5.2).

In this case, the rate at the time of the swap (21:00 GMT) was 107.64; in the trader’s report, this operation will look as shown in the table. 4.5.3.

It must be remembered that when moving a position from Wednesday to Thursday, the swap difference will be charged or accrued in triple amount. This is due to the fact that the current foreign exchange market operates on spot conditions. Spot conditions require settlement of a transaction on the second business day after the transaction is concluded.

For example: today, Monday March 2, 2003, Bank A entered into a deal with Bank B to purchase 1 million USD for JPY at a rate of 108.00 on spot terms. On Wednesday, March 4, 2003, Bank A will transfer 108 million JPY to Bank B, which will supply Bank A with 1 million USD on the same day.

Content

Obliges any bank in America to form a certain amount of cash reserves. They are needed to conduct transactions with clients. This is necessary in case most clients suddenly want to withdraw all their deposits. In this case, the banking institution may simply not have enough finances, and then, most likely, another banking crisis will occur. It is because of this that the Fed sets certain limits for the amount of required reserves, the size of which is affected by the Fed rate.

What is the Federal Reserve System

Every day, banks carry out a colossal number of transactions, and each of them tries to increase their volume in order to increase their profit. Sometimes clients come in without warning and withdraw large amounts of money, causing the financial institution's reserve requirement level to fall below Federal Reserve guidelines. This will cause many problems for the bank in the future.

The Fed interest rate is the rate at which the Central Bank issues loans to American banks. Through these loans, financial institutions increase the level of reserves in order to comply with Federal Reserve requirements.

In most cases, banks borrow from each other, but if banks are unable to help their “colleague,” the latter turns to the Fed. According to the law, this loan must be returned the next day. The Fed has a negative attitude towards such loans. If they also become more frequent, the Fed has the right to tighten requirements for required reserves.

Why do you need an interest rate?

Its necessity is as follows: it serves as the basis for calculating other rates in the state. In addition, Fed loans are low-risk loans because they are issued only for one night and only to banking institutions with excellent credit histories.

If we consider the stock markets, an increase in rates is an increase in the cost of capital of an organization. That is, for enterprises whose shares are traded on the stock exchange, this is a negative point. It's different for bonds - raising rates leads to lower inflation.

The foreign exchange market is a little more complicated; here the Fed rate affects rates from several sides. Of course, there is a course; all transactions with currencies are based on it. But this is only a small part of the scheme. the world, responsible for most of the transactions carried out in the world on the foreign exchange market, are the movements of capital, which are caused by the desire of investors to find greater profits from investments. Taking into account the state of all types of markets, including the housing market and inflation data, in any country, an increase in the discount rate has both a positive and negative impact on profitability.

Prior to this, the Fed rate increased on June 29, 2006. For 2007-2008 The Federal Reserve slowly lowered it until it approached the lowest level of 0-0.25% in the winter of 2008.

Fed rate hike

We will consider below what this action will lead to. Labor market indicators for small and medium-sized businesses in America today are the highest, and the unemployment rate has dropped by half compared to 2009. The Fed believes that the recovery of the labor market has every chance of spurring inflation and increasing wages, thereby supporting the state's economy.

In 2007-2009 In the United States there was a crisis in the housing market and in the banking sector. The Fed was then able to keep the state's economy from going into depression.

Can the Fed survive a rate hike today? Analysts here make different assumptions. Some argue that the Fed was able to smoothly keep the state's economic situation afloat. And then a 0.25 point increase in the Fed rate will have minimal impact on the US economy. Others point to a very low inflation rate, arguing that the Fed could thereby collapse world markets and create the preconditions for an increase in the dollar if the Fed is in a hurry to make a decision.

The Federal Reserve Chairman says rate hikes are planned to be gradual. Experts in this area believe that the growth rate will be lower compared to the time of the last session, which began in 2004. The final rate of the discount rate will not exceed 3%.

Is everyone ready for change? Some corporations took advantage of the low rate time to borrow through the bond market. And now they say that they see no reason to worry about a slight increase in rates, believing that the market has already been able to use all the opportunities. At the same time, a large number of organizations that rely only on low rates will not be able to withstand their rise, and thus they will have problems as their borrowing costs increase.

When looking at investors, most experts believe that the Fed has given them plenty of warning of its intentions, and traders have likely already factored future growth into their strategies. But some experts are confident that there will still be volatility from such serious adjustments in monetary policy, given that the indicator has been zero for seven years.

Below we will consider how the Fed discount rate can affect global markets.

The discount rate and its impact on the English economy

Most economists believe that the Bank of England will follow the American Central Bank in raising rates. History has seen more than once how the discount rates of the United States and England were adjusted simultaneously.

Today, the economic growth of Foggy Albion is stable, and the demand for labor is high. The head of the Bank of England emphasized that perhaps growth will become smooth.

The discount rate and its impact on Russia

The Central Bank of the Russian Federation will not be able to avoid the negative effects of the strengthening of the US currency and the growth of the discount rate. This fact will lead to problems with the build-up of international reserves, which have decreased to $365 billion from an amount of over $500 billion.

Experts believe that, of course, rising rates will have a negative impact on the economy of our state. But this influence will not be as strong compared to other developing markets, since, as a result of sanctions, the Russian Federation is no longer so strongly connected economically with the United States.

The discount rate and its impact on Europe

An increase in the discount rate may have a negative impact on the economic situation of the EU countries; this may cause increased volatility and unpredictability of the market.

The head and other politicians believe that the recent wave of volatility in world markets will have a strong negative impact on the recovery of the European economy.

The discount rate and its impact on China

In response to the question of what would happen if the Fed raised rates, the Chinese authorities believe that they will be able to avoid the direct impact on the state economy from the increase in rates, and the impact will be small.

The Federal Reserve rate has a limited impact on the Chinese economy. Internal factors have a negative impact on the state’s economy, for example, a drop in the competitiveness of products produced for export and overproduction.

The discount rate and its impact on Japan

Inflation here is also almost zero. Therefore, if the Fed refuses to tighten policy, sooner or later there will still be a significant difference between US and Japanese rates.

According to some experts, raising the Fed rate will make owning the American currency more attractive. But at the same time, the weakening of the Japanese currency will negatively affect the share of profits of importers and increase the share of profits of large exporters.

What stage is the market at now?

The point of raising the Fed's interest rate is to circumvent market bubbles caused by the Fed's very loose monetary policy over a long period of time.

To assess the current situation, it is better to conduct a retrospective analysis. It is important to note here that identifying the stages of the economy is a very subjective point. 2016 will likely be in the middle of the economic cycle.

Experts, however, do not expect sudden movements from the Fed. But there is a danger in a rather late or significantly slow move of such a move as the Fed rate hike, which could lead to a rapid increase in inflation and faster growth of the Fed, which will have an extremely negative impact on the stock market.

The conclusion to the discussion about what the Fed's rate hike will lead to can be formulated as follows: before the Federal Reserve announces an increase in interest rates, it is better to get rid of shares of American companies. After rates begin to rise, you can wait for a market correction and purchase American assets again.

While the theories of macroeconomic balance and PPP determine the long-term prospects for the development of the exchange rate, its short-term fluctuations are better explained using monetary and related theories of the exchange rate. The broadest approach is that the investor has a choice whether to hold his savings in non-yielding cash or invest them in any asset (bank cash deposits domestically or internationally, public or private, national or foreign securities). papers, real estate, gold, paintings by great masters, antique furniture, etc.), which, from his point of view, will rise in price in the future and generate income.

Asset approach(assets approach) - the exchange rate is determined by the ratio of the return on investment of money in various assets within the country and abroad that generate income, primarily in bank deposits and securities.

According to this approach, the movement of money between countries consists of two components - a continuing-flows component, which is described by the current part of the balance of payments, and a stock adjustment component. If short-term fluctuations in the exchange rate as a result of the intercountry movement of money when paying for exports and imports are explained through the balance of payments approach discussed above, then its fluctuations as a result of differences in the return on investments in national and foreign assets are explained through the approach to the exchange rate from the point of view of assets.

Prices of goods, as shown above, change with a certain time lag after the corresponding macroeconomic conditions have changed, and do not keep pace with changes in the exchange rate. This is due to the fact that the economy needs some time to adapt to the new level of money supply: make decisions on increasing civil servants’ salaries and pensions, recalculate costs, etc. The interest rate, which represents the income on income-generating financial assets, as well as foreign exchange exchange rate reacts much faster to changes in macroeconomic conditions. Let's say that an investor does not want to keep his money in cash and not receive interest and seeks to invest it in interest-bearing financial assets. He has an alternative - to invest in his country in national currency or abroad in foreign currency. To do this, he needs to take into account at least three economic indicators: the interest rate in his country, the interest rate abroad and the dynamics of the exchange rate.

Foreign Investment Rule(foreign investment role) - income on foreign investment in national currency is equal to the sum/difference of the interest rate abroad and the percentage of depreciation/growth of the national currency.

Let's denote:

r d - domestic interest rate;

r f- foreign interest rate;

E t - exchange rate of the national currency at time f;

E 1+1 - exchange rate of the national currency at time t-1 in the future (forward rate);

Expected investment revenues, assuming that the period for quoting the interest rate and the forward rate are the same, for example, the interest on a 3-month government bond and the forward rate for three months ahead. Then the expected income (q) from investments in foreign securities will be:

(11.6)

To decide where - at home or abroad - it is more profitable to invest, it is necessary to compare the interest rate within the country with the expected income when investing abroad, i.e.:

If the difference is positive, then investments within the country are more profitable and there is no point in investing abroad; if the difference is negative, investments abroad bring greater income. Note that the fractional part of equation (3.6) can be either positive if the expected future exchange rate of the national currency is lower (i.e. its numerical value is greater) than its current exchange rate, or negative if the expected future exchange rate of the national currency is higher . This means that a change in the exchange rate in the future may mean both a depreciation of the national currency (+) and its appreciation (-), which will directly affect the assessment of the return on investment. Thus, in the event of a depreciation of the national currency, the percentage of its depreciation is added to the interest rate abroad, and in the event of an increase, it is subtracted. Thus, in accordance with the theory of interest rates, with freedom of international movement of capital, the demand for national and foreign assets is determined solely by the level of income paid on them - the interest rate and adjusted for the level of the exchange rate predicted at the time of expiration of the deposit agreement exchange rate.