Money, Banking, and International Finance

only grew by 5%. Unfortunately, a person facing this scenario would lose nearly 5% of his or
her purchasing power every year.
The International Fisher Effect relates the real interest rate to a nominal interest rate in a
foreign country. We build upon the Law of One Price for financial transactions. For instance,
international investors should earn comparable returns in foreign countries as compared to their
home country after we adjust their returns to a currency's exchange rate. Thus, the currency
exchange rates reflect interest rate differences the international investors can profit. We must be
careful because investors are not trading commodities. They choose whether to invest in a
foreign country. We define the mathematical notation as the following:

 Domestic nominal interest rate in APR is id, while rd represents the domestic rate of return

of the investment in T days.

 Foreign nominal interest in APR rate for an investment for T days is if.

 Percent change in the exchange rate from the beginning of the investment period to the

time period T is e.

We derive the International Fisher Effect with Equation 17. Domestic return is the interest
rate earned by a $1 investment in a foreign bank account after T days of maturity converted into
the domestic country’s currency. If the domestic currency is appreciating, a positive e, then this
weakens the return on the foreign investment, making rd smaller. On the other hand, if the
domestic currency is depreciating, a negative e, subsequently, the returns to the foreign
investment become greater. Thus, both the foreign interest rate and change of currency exchange
rate determine an investor’s real return.

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360

1 1 1

T

rd +e= +if^ (17)^

Investor can invest in his home country for T days. We calculated his return on his home
bank deposit in Equation 18.

360

T

rd=id ( 18 )

An international investor is indifferent between investing within his home country or
investing in a foreign country. Consequently, arbitrage drives the rate of returns together. First,
we solve Equation 17 for rd. Then we set Equations 17 and 18 equal to each other because
international arbitrage causes both investment returns to converge to the same rate, shown in
Equation 19.