What Does a Rate Analyst Do?

The interest rate difference is the difference between the national currency and foreign currency interest rates. The US federal funds rate minus the Chinese rate is the Sino-US interest rate difference. [1]

Interest rate difference

The interest rate difference is the difference between the national currency and foreign currency interest rates. The US federal funds rate minus the Chinese rate is the Sino-US interest rate difference. [1]
Different foreign exchange currencies have different deposit interest rates, so how do you convert a currency with a low interest rate into a currency with a high interest rate to earn this spread?
Suppose the one-year sterling deposit rate is 5.5%, and the US dollar deposit rate is 5% over the same period, and the spread between them is 0.5%. Assuming that the current exchange rate between them is 1 pound = 1.5 US dollars, then if the exchange rate fluctuations are not considered, the sum of principal and interest of a one-year $ 1,500 one-year deposit is $ 1575 [1500 US dollars × (1 + 5%)] , Converted into British pounds for 1050 pounds ($ 1575 ÷ $ 1.5). However, if you convert this 1,500 US dollars into 1,000 pounds first, the sum of principal and interest for the previous year will be 1055 pounds [1,000 pounds (1 + 5.5%)]. In short, for the same amount of deposits, deposits in sterling are 0.5% more spread than deposits in US dollars. But this can only be achieved with the exchange rate unchanged.
In other words, if the exchange rate fluctuation between them is 1 pound = 1.48 US dollars when the one-year deposit term expires, the sum of 1055 pound principal and interest converted from the sterling deposit is converted into U.S. dollar 1561.4 (1055 x 1.48 US dollars) On the contrary, it is 13.6 US dollars (1575 US dollars-1561.4 US dollars) less than US dollar deposits. This is because the exchange rate between the British pound and the US dollar has reached 1.33% in one year [(1.50 US dollars-1.48 US dollars) / 1.50 US dollars. Therefore, when this exchange rate is greater than the interest rate spread, the arbitrage transaction is not worth the money.
In fact, due to the supply and demand relationship, in the foreign exchange market, the forward exchange rate of currencies with high interest rates will indeed decline, and the exchange rate difference is greater than the interest rate difference. Therefore, in arbitrage transactions, the factors of the exchange rate difference and the interest rate difference must be integrated Think about it. Of course, if there is a forward foreign exchange market, people can use the swap method to not only avoid the risk of the exchange rate fluctuations mentioned above, but also to earn spreads. This approach is called offset arbitrage.

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