Spot Rates, Forward Rates, and the Interest-Rate Differentials: Comment

Abstract

In a recent article, John Pippenger developed a theory of interest rate arbitrage within a simple Fisherian framework.1 Among the implications he derived from this approach to international finance was the contention that, the interest rate arbitrage theory is developed in a Fisherian context, then the major determinant of both the forward premium and the interest rate differential is the difference in expected rates of inflation. Under this interpretation, the forward premium tends to equal the interest rate differential even though no arbitrage funds are available. (p. 380). This claim, which contradicts the standard interest rate arbitrage theory's reliance on arbitrage funds to force the rates to correspond to interest parity, overlooks the crucial assumption on which this Fisherian analysis is based. Pippenger maintained that, in an abstract, two-country world, when it includes capital flows, equates all relative and that, ;'The equalization of real rates of interest by trade when it includes capital flows is crucial to the analysis developed here. These capital flows which force the real rates of interest into equality are the same arbitrage funds which tend to force interest parity to hold under the standard theory. Trade and capital flows, which generate a movement towards equality of relative prices and real interest rates, are a direct consequence of individuals' desires to purchase goods where they can be acquired most cheaply and invest where they can secure the highest yield, so that they may maximize their wealth. In order to make similar domestic and foreign investments truly comparable, it is necessary to cover the repatriation of those funds invested abroad with a forward exchange contract to eliminate the risk of a disadvantageous shift in the exchange rate. If this exchange risk is ignored and there is an uncovered capital flow, then the relevant yield considerations are the appropriate interest rates. The capital will flow to the country with the higher nominal interest rate. These flows would tend to equalize nominal interest rates. So if the capital flows were uncovered, then the assumption of equality of real interest rates which serves as the basis for Pippenger's Fisherian approach would be invalid and that approach would be inappropriate. With forward coverage, the relevant yield considerations are between the domestic interest rate for domestic assets and the foreign interest rate plus the premium on foreign ex-