An empirical study of the international Fisher effect.

Abstract

The international Fisher effect is identified as part of the four-way equivalence model.

This model outlines a relationship between exchange rates, interest rates and inflation

rates. The international Fisher effect, specifically, states that the difference in interest

rates between two countries is an indicator of the expected change in exchange rates of

their currencies.

The aim of this paper is to test the validity of the international Fisher effect between

South Africa and the UK. The understanding of the exchange rate movements is vital for

management decisions, investment activity and policy making for central banks and

government.

Data has been collected for a sampling period beginning in July 1995 and ending in April

2001. Interest rates in the UK and South Africa are recorded for this period. A record of

exchange rate movements for the same period has also been compiled. Using this data, a

simulation of an uncovered interest arbitrage was carried out. This was done by taking

£100 from the UK, converting it to Rands and investing those Rands in a South African

bank. At the same time, £100 was also invested in a UK bank. As interest accrued over

the test period, interest rates in both countries changed, exchange rates fluctuated and the

balance in the South African account was compared to the balance in the UK account.

According to the model, the real balances in both the accounts should remain equivalent

over the sampling period.

It was found that interest rates in SA were higher, more volatile and less cyclic than those

in the UK. As predicted by the model, the exchange rate (in R/£) constantly increased

over the sampling period. Reasons for the higher interest rates in SA include a low

national savings rate, high inflation, the South African economies vulnerability to events

in the international market and the reserve bank's monetary policies.

The simulated arbitrage was found to be profitless and the balances of the two simulated

investment accounts were found to be statistically similar. There were, however, some

short term deviations from the theory. The value of the SA account was lowest during

times of high interest rates in SA, when there was volatility in the forex market and when

the exchange rate was at peaks in the cycle. Nevertheless, the exchange rate - interest rate

relationship always returned to equilibrium.

The risk and unpredictability associated with the international market is high while only

small chances exist to achieve economic gain from borrowing from low interest rate

environments (or investing in countries where the interest rates are high). It was

concluded that the international Fisher effect, between the UK and South Africa, for the

period studied, had significant short term deviations but is valid over the medium term.

The implication for business practice is that stakeholders should be conservative when

faced with risk associated with foreign exchange exposure unless, as is the case with

speculators, it is their core competence to predict macroeconomic trends and profit from

beating the market.