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?