Interest Rate Differentials Research Articles

Exchange Rate Dynamics and Monetary Fundamentals: Evidence from South Asian Countries

This paper examined the role of monetary fundamentals in determining nominal exchange rate changes in South Asian countries. The Vector Autoregressive (VAR) technique and Autoregressive Distribution Lag (ARDL) were used. Results from the VAR indicate that the exchange rate responds to shock originating from differences in money supply, inflation differential, interest rate, and real income differential and are consistent with the short-run predictions of the monetary model of the exchange rate. The results show that inflation and interest rate differentials are responsible for the majority of changes in exchange rates in the short run. The conclusion from the result is that, particularly in the short run, monetary fundamentals are the primary causes of exchange rate fluctuations in South Asian countries.

THE DYNAMICS OF EXCHANGE RATES, INFLATION, AND TRADE BALANCE IN A SMALL OPEN ECONOMY (CASE STUDY OF SIERRA LEONE)

Sierra Leone experiences a persistent trade deficit problem. Currently, there is a vacuum in the literature employing recent data and suitable approaches to address the issue of non-stationarity and dynamic interaction between macroeconomic variables in influencing the trade deficit in Sierra Leone. This study examines the relationship between Sierra Leone's trade balance, inflation, and exchange rate using quarterly data from 2005 Q1 to 2023 Q3. The focus is on understanding how the exchange rate and inflation impact Sierra Leone's trade balance in both the short and long term. To achieve this, the study utilizes the VAR/VECM model to depict the dynamic interaction between the trade balance, exchange rate, and inflation. It also employs Granger Causality analysis to determine the most appropriate ordering among the macroeconomic variables in the model and Impulse Response Function (IRF) analysis to test the hypotheses regarding the trade balance response to exchange rate shocks and inflation. The empirical results confirm the existence of cointegration, indicating a long-term balance between the trade balance, exchange rate, inflation, and other macroeconomic variables such as GDP growth and interest rate differentials. Moreover, the dynamic prediction analysis using the IRF method supports the J-curve hypothesis in Sierra Leone and suggests that inflation can reduce the performance of the trade balance. These findings highlight the need for Sierra Leone to implement a comprehensive strategy to adjust the exchange rate and curb inflation to improve the trade balance and enhance external economic stability.

Monetary Policy Independence during Reversal Phases of Domestic-Foreign Interest Rate Differentials<xref ref-type="fn" rid="fn001">*</xref>

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Green supply chain finance strategies with market competition and financial constraints

In the context of sustainable development, market competition is intensifying, and financial constraints have emerged as a significant hindrance to green project investment. Green Supply Chain Finance (GSCF), characterized by long-term collaboration, has emerged as a crucial financial approach to mitigate corporate financial limitations and channel capital flows into environmentally friendly industries. We propose a two-echelon supply chain with one supplier and two competing retailers over a single period and investigate ordering, sales, and financing decisions simultaneously under competition. Retailers constrained by financial considerations may secure GSCF or traditional bank financing (BF) loans. This study investigates the influence of competition on pricing and sales strategies during the selling season. The results demonstrate that retailers select between clearance and responsive selling strategies based on the level of market competition. During the ordering season, retailers share the product market equally when interest rates are uniform, and the supplier formulates a supply chain contract while considering the financing interest rate. In the presence of differential interest rates, retailers may not always opt for the GSCF, even when they offer an interest rate advantage, due to the comprehensive impacts of operational and financial strategies. Remarkably, competitive retailers do not choose the GSCF when their initial green investment capital surpasses a certain threshold.

ANALYSIS OF INTEREST RATE SPREAD ON FINANCIAL RESILIENCE OF QUOTED BANKS IN NIGERIA

This paper examined the effect of interest rate spread (IRS) on financial resilience of quoted Nigerian banks from 2007 to 2021. Specifically, the paper examined the effect of deposit rate, lending rate, and interest rate differential on financial resilience of quoted Nigerian banks. The paper collected data from the CBN bulletin (2021) and Security Exchange Commission (SEC) annual report (2021) and the World Bank data base (2021). The study covered all the twenty one (21) commercial banks quoted in the Nigerian exchange group as of 31st December, 2021 using the census sampling approach. The study reported that, deposit (savings) rate/cost has a positive (coef=0.056833) insignificant (p-value=0.5327.5%) effect on financial resilience (bank z-score) of quoted banks in Nigeria. By extension, deposit (savings) rate/cost has a minimal effect on banks’ financial resilience. However, lending (borrowing) rate/cost interest rate differential (prime lending/borrowing rate/cost less savings/deposit rate/cost) exerted negative (coef= -0.527024&coef= -0.160001 respectively) significant (p-value=0.0001<5% &p-value=0.0194<5%) effect on financial resilience (bank z-score) of quoted banks in Nigeria.Hence, the paper concludes that, high lending rate and interest rate differential reduce financial resilience of quoted Nigerian banks. As such, the study submits that, the apex banks must ensure that, the rising lending rate should be discouraged. This if not cautioned; it has the capacity to reduce the productive capacity of the private sector. Again, to encourage more depositors to invest their depositors’ funds, the ape banks should raise the deposit rate. Lastly, the Nigerian banks are adjourning to keep their interest rate differentials relatively low.
 Keywords: Analysis, Interest Rate Spread, Deposit Rate, Lending Rate, And Interest Rate Differential, Financial Resilience Quoted Banks.

On the role of interest rate differentials in the dynamic asymmetry of exchange rates

Motivated by the lack of empirical evidence in favour of the uncovered interest rate parity rule, we revisit the informational content of interest rate differentials (IRD) to explain daily exchange rates variations. Proposing a novel version of a GARCH model, we allow for the IRD to impact on the time-varying conditional asymmetry of the depreciation rate. We find IRD to be a significant factor for the Euro (EUR), the Swiss franc (CHF), the Swedish Krona, the Japanese Yen and the British Pound. These findings empirically support currency crash theories, suggesting that the larger the difference between interest rates, the more likely the high-yield currency appreciates on average but also exhibits greater risk of a large depreciation. Compared to random walk and buy-and-hold benchmarks, we document superior out-of-sample mean returns of a trading rule exploiting IRD information for EUR and CHF.

Identifying Monetary Policy Under Fixed Exchange Rates in a Small Open Economy

Purpose: This paper is an empirical investigation of the transmission of monetary policy in a small open economy with fixed exchange rates. The paper argues that under a fixed exchange rate system and free mobility of capital, the ability of monetary policy actions to affect the real variables of the economy is limited and constrained by maintaining the peg. Theoretical framework: The study's theoretical framework examines how Jordan's monetary policy, influenced by a fixed exchange rate with the U.S. dollar, responds to domestic and external shocks, with an emphasis on the transmission of these shocks through key economic variables. Design/Methodology/Approach: A two-country structural macroeconomic model has been developed to describe the small economy that explicitly incorporates an interest rate differential. Findings: Using Jordan as a case study during the period when its currency was pegged to the U.S. dollar, vector auto-regression analysis reveals that there is evidence of a strong U.S. monetary policy influence on the Jordanian economy. The results show that adjustment of the policy rate by the central bank of Jordan in response to Federal Reserve actions has no significant impact on output while the interest rate differentials tend to have an immediate influence on inflation with short lags, albeit small in magnitude. Research, Practical & Social implications: The research provides insights that can inform effective monetary policy strategies in small open economies like Jordan, offering implications for policymakers and contributing to economic stability. Originality/Value: The originality of this study lies in its comprehensive analysis of Jordan's monetary policy within the context of a small open economy, offering valuable insights into the effects of external shocks, exchange rate regimes, and policy responses on key economic variables.

Currency carry trades, risk management, and firm value: Evidence from Korean banking industry

I examine the relationship between a firm's risk-taking, risk management, and firm value using a unique dataset of banks' currency carry trades. I find that banks can significantly increase bank value by hedging market and credit risks while engaging in carry trades. I also find that interest rate differentials stemming from monetary policy divergences have a significant impact on banks' risk-taking. The empirical results show that banks can increase their market value more when the interest rate differential is narrower, more sharply when they actively engage in currency carry trades, and most sharply when they actively hedge interactive risks.

Causes of Exchange Rate Volatility

This study examined the determinants of exchange rate volatility basing evidence on 7 African countries; Niger, Sudan, Cameron, Equatorial Guinea, Tunisia, Congo, and Cote D’Ivoire from 1990-2023. The study conducted the Autoregressive Distributive Lag (ARDL) bounds testing for co-integration and also estimated the error correction model. Furthermore, ARCH and GARCH models were analyzed to measure the volatility of a time series by fitting an autoregressive model to the squared residuals of the time series. The ARCH and GARCH results suggest the volatility of the exchange rate markets in the aforementioned countries is not random. The speed of adjustment of the volatility in the exchange rate of the Sudanese economy is 39%, in Niger Republic it is 50%, in Cameroon it is 52%, in Tunisia it is 55%, in Congo the speed is 32%, in Equatorial Guinea, the speed of adjustment is 58% and in Côte D’Ivoire the speed is 45%, respectively. The study found that the determinants of exchange rate volatility among African countries vary depending on the specific country. The observed volatility in the Sudanese exchange rate was anchored by the significant positive influence of inflation and income differentials as well as the significant negative influence of interest rate differential. In Niger Republic, exchange rate volatility was driven by the significant positive influence of productivity growth and money supply as well as the significant variation in oil prices and interest rate differentials. The observed short-run volatility in Cameroon's exchange rate was significantly and positively influenced by inflation differential and money supply variation whereas it was significantly but negatively propelled by interest rate differential and oil price shock. In Tunisia, exchange rate volatility was stimulated by the significant positive influence of inflation differential, productivity growth, oil price shock, and the significant negative role played by trade balance. The observed short-run volatility in the Congolese exchange rate was induced by the significant positive impact of inflation differential, income differential, trade balance, variation in money supply, and the significant negative impact of interest rate differential. In Equatorial Guinea, the observed exchange rate volatility was determined based on the significant and positive impact of differential in the inflation rate, oil price shock, changes in the money stock, and the foreign balance of trade. The observed volatility in the Côte D’Ivoire exchange rate was significantly and positively driven by the differentials in inflation rate, interest rate, and income level, the foreign trade balance but significantly stimulated by the negative influence of oil price shock. The general policy advice is that governments of all the countries covered by the study should implement exchange rate controls to limit the volatility of their currency fluctuation by imposing a limit on the amount of foreign currency that can be traded in the country. African governments should monitor the inflation differential between their own country and their trading partners to see if it is becoming too large. If it is, the government might raise interest rates to make its currency more attractive to investors.

Currency Substitution and General Business Indicators in Nigeria

Purpose: This paper examines the effects of currency substitution on general business indicators in Nigeria. Theoretical framework: This paper is based on portfolio balance theory which is concerned with interest rate adjustment and achieving the market equilibrium on currency substitution aggregate. Design/Methodology/Approach: The paper employed appropriate econometric techniques such as the cointegration and error correction model (ECM) approach to examine the long run and short run attendant relationships. Findings: Empirical findings from this study indicate that there is a long run relationship between currency substitution and general business indicators variables as inflation, interest rate differentials, and exchange rate depreciation in Nigeria, the magnitudes of the impact of each are weak. Research, Practical & Social implications: The construction and analysis of currency substitution and general business environment by this study have provided relevant information for Nigerian economy in preparing for substantial currency substitution that would give clear understanding of the aggregate business environment on existing currency substitution policy that may lessen the anxiety of the apparent environmental challenges faced by the countries, and this will further provide policy directions for future currency substitution reforms in the various segment of the economy. Originality/Value: The originality of this study lies in its analysis of currency substitution and general business environment. Furthermore, the study highlights the relevance of tackling regulatory issues to ensure the safe and effective use of currency substitution.

Liquidity premiums, interest rate differentials, and nominal exchange rate prediction

AbstractWith the use of daily panel data for industrial countries, we study the essentialness of liquidity premiums and interest rate differentials in predicting nominal exchange rates at short horizons. We find that information about higher‐order moments of exchange rates helps predict nominal exchange rates. Before the global financial crisis, interest rate differentials were crucial for forecasting exchange rates. Interest rate differentials and liquidity premia provide additional information for predicting nominal exchange rates in the post‐crisis period even if we have controlled for latent fundamental exchange rates. Moreover, the economic significance analysis results echo those of the statistical significance analysis.

Do term premiums matter? Transmission via exchange rate dynamics

The macroeconomic effect of term premiums is a controversial issue both theoretically and quantitatively. In this paper, we explore the possibility that term premiums affect inflation and the real economy via exchange rate dynamics. For this purpose, we construct a small open economy model with limited asset market participation, focusing on the empirical observation that uncovered interest parity holds better for longer-term interest rate differentials. A quantitative exercise using Japanese and U.S. data shows that changes in term premiums, particularly those made by the central bank's bond purchases, have sizable effects on Japanese inflation rates via exchange rate dynamics.

Retail Interest Rate Differentials in the Eurozone: A Co-Integration Analysis Approach

Over the last decades, despite the remarkable progress toward the harmonization of banking regulation, interest rate differentials in the Eurozone remain large. In this context, rejecting the law of one price as a measure of financial integration, this paper applies the co-integration technique to investigate the presence of a long-run equilibrium relationship among retail interest rates. The data sample of the co-integration analysis conducted in this paper includes three (3) loan and two (2) deposit interest rates data sets from the 12 original Eurozone member countries for the time period 2000–2020, filling in that way the gap in the existing research by extending the application of this methodology to incorporate an updated database. The empirical findings of the paper provide evidence that in most of cases, there is a co-movement and a long-run equilibrium relationship between retail interest rates. On the basis of the co-integration approach, these findings are being perceived as a signal of retail banking market integration in the Eurozone.

Global financial uncertainty shocks and external monetary vulnerability: The role of dominance, exposure, and history

The paper investigates the role of country-specific factors in external monetary vulnerability to global uncertainty shocks. We identify three structural determinants that may shape cross-country heterogeneity in the monetary response to financial uncertainty shocks: dominance in the international monetary and financial system, exposure to fickle capital flows, and volatile macrofinancial histories. Based on vector autoregressions, we operationalise external monetary vulnerability through an index based on estimated impulse responses of interest rate differentials, exchange rates, and foreign exchange reserves from quarterly data for 36 countries. We then investigate the covariates of this index and find that history and exposure are most strongly related to a country’s external vulnerability. In particular, past currency and sovereign default crises as well as exposure to non-bank foreign investors and portfolio debt may increase sensitivity to a global uncertainty shock. By contrast, macroeconomic fundamentals such as public debt appear less relevant.

Real interest rate parity in practice: Evidence from Asia‐pacific economies

AbstractThis research investigates the relationship between real interest rate parity and the interest parity puzzle across several economies in the Asia‐Pacific region. Unlike previous studies, we establish a comprehensive theoretical framework for parity and utilize macroeconomic and financial market data from 15 economies in the region to examine it. Our findings indicate that most countries exhibit mild deviations from parity, with real interest rate differentials strongly correlated with changes in the real exchange rate and interest‐exchange rate interaction terms, particularly in middle‐income economies. While interest parity puzzle is also observed in high‐income economies, it is less prevalent in most middle‐income economies. Our analysis reveals that income levels are key drivers of deviations from parity in this model, with interaction terms also playing a crucial role in most cases. The implication here is that for carry trades, investors place significant importance on risk factors, especially in economies with relatively low risk. This insight helps to clarify a puzzle in this area. Therefore, it is imperative that investors should take into account the impact of interest‐exchange rate interaction terms when making carry trade decisions. Lastly, we underscore the significance of ex ante price forecast approaches in achieving parity.

Research on the Impact of Xizang's Inclusive Financial Service Capabilities on the Development of Agriculture and Animal Husbandry

In order to maintain the development of rural finance and small and micro enterprises, the state has introduced a series of policies, including loan interest rate differentials, tax exemptions and concessions, re-loans and other related control policies. Among them, inclusive finance has a significant effect, which is very good. It supports the development of rural economy, expands the scope of financial services, increases the convenience of rural financial services, reduces the cost of financial services, and allows rural residents to truly enjoy financial services. This paper mainly introduces the meaning of inclusive finance, financial services and related theories. On this basis, it elaborates on the mechanism of inclusive financial service capabilities on agriculture and animal husbandry, as well as the experience of Xizang's inclusive financial service capabilities and agricultural and animal husbandry development. Based on the impact of the Xizang’s Autonomous Region's inclusive financial service capability index, the Xizang’s Autonomous Region's industrial structure, and the Xizang Autonomous Region's fiscal expenditure proportion on the development of agriculture and animal husbandry. The experimental results finally provide policy recommendations for Xizang’s inclusive financial service capabilities to support the sustainable and healthy development of agriculture and animal husbandry.

Convenience yield and real exchange rate dynamics: A present‐value interpretation

AbstractIn this paper, we empirically investigate the relationship between the convenience yield of government bonds and the real exchange rates using monthly data from 1999 to 2018. We extend the conventional models, based on the present‐value relationship between the real exchange rate and economic fundamentals, while explicitly considering the role of the convenience yield. Empirical results suggest that our present‐value models can capture the dynamic properties of the real exchange rate documented in the literature, including high persistence, excess volatility and excess co‐movement compared with real interest rate differentials. We also find that the sum of expected convenience yields significantly drives real exchange rate movements. Moreover, we find that foreign exchange swap market friction also plays a role in explaining real exchange rates. Finally, we find that monetary policy at the zero lower bound may be essential in real exchange rate modelling.

Impact of interest rate differential, exchange rate changes and political stability on Foreign capital inflow in Nigeria: Discrete threshold regression model

Lack of investable capital has slowed down the development process in many developing nations, including Nigeria, and this has sparked empirical research on the factors affecting foreign capital flow. Therefore, the purpose of this study was to investigate the effects of interest rate differential, exchange rate changes, and political stability on the entrance of foreign capital into Nigeria between 1981 and 2021. To investigate the impact of the factors on foreign capital inflow in regimes with low and high interest rate differentials, the study used a discrete threshold regression model (DTRM). The study discovered an interest rate differential threshold value of 3.68 percent, indicating that an interest rate differential high and over the predefined threshold promotes a favorable and considerable inflow of foreign capital into the nation. Additionally, the country’s capital inflow is influenced by political stability and exchange rate fluctuations. The implication is that investors evaluate a country’s IRD in relation to other risk factors (political and macroeconomic) and will only invest if the IRD is higher than3.68 percent since it will balance out other opportunity costs at home and risk factors in the receiving country’s economy.

An Empirical Analysis of the Financial Revolving Door Hypothesis: An Evidence from Pakistan

A simultaneous equation technique was used to investigate the relationship between capital flight (CF) and external debt (the financial revolving door theory) in Pakistan. Time series data from 1984 to 2020 are used to determine the algorithm. Using an appropriate approach, the research contributes to the measurement of capital flight from Pakistan. Three Stages Least Square is used in this study to examine institutions' relationships with capital market literature. (3SLS method). The study found that poor governance, inflation, external debt, and interest rate differentials caused CF and capital outflow by creating an unstable and unfavourable environment for savings and investment. CF causes external borrowings and world capital market borrowing. Capital retention is crucial due to this and ecological development policies. The Granger Causality Test validates Pakistan's Financial Revolving Door Hypothesis. The study concludes with policy suggestions.

Currency exchange rate predictability: The new power of Bitcoin prices

We show that Bitcoin prices have surprisingly predictive power for nominal currency exchange rates, both in-sample and out-of-sample. The predictability follows from the fact that Bitcoin prices are forward-looking: Bitcoin efficiently incorporates expectations of currency exchange rates and their drivers, as exchange rates serve as a fundamental of Bitcoin. We examine the Bitcoin-based exchange rate prediction model in the autoregressive distributed lag (ADL) specification and the error correction specification. Forecasts based on both specifications outperform different benchmarks for some of the exchange rates. The outperformance is most pronounced at the daily horizon using the ADL model. Bitcoin-based forex trading strategies generate Sharpe ratio gains relative to the US risk-free rate and the carry trade. Bitcoin returns incorporate extra knowledge of future interest rate differentials after controlling for lagged exchange rate movements. Our result is inspiring for currency market participants, given the well-documented difficulty in exchange rate prediction.