RELATIONSHIP BETWEEN INTEREST RATES AND EXCHANGE RATES

Relationship between interest rates and exchange rates



Relationship between interest rates and exchange rates

Introduction

Exchange rates and interest rate risks are significant financial and economic factors affecting the value of widespread stocks. There are significant causes why the stock returns of banks can be responsive to interest rate and exchange rate changes. (Collin, 2003, 70)Firstly, the instability move hypothesis proposes that random alarms can induce higher instability in financial markets and because of contagion consequences which are largest in more volatile markets, investors as well as banks may gaze overseas to invest in alternate financial assets. If worldwide portfolio diversification furthermore outcomes in a boost in the instability of those come back, then larger exposure to interest rate and exchange rate risks is like to sway the stock returns of banks if really such data is impounded into their stock prices. So the significances of the arbitrage charge idea (APT) will request if really interest rates and exchange rates are cost components that constitute significant components in the equilibrium cost of stocks. In equilibrium, the stock price of financial organisations (FIs) encompassing banks would disagree as asserted by their sensitivity to interest rate and exchange rate changes. Indeed, supply empirical clues that both interest rates and exchange rates are cost in the stock market for US banks. (Collin, 2003, 70)

Discussion

Interest rate and exchange rate changes have been shown to exactly sway the incomes and charges of financial institutions. As the biggest US banks have an important percentage of their procedures in foreign nations, interest rate and exchange rate changes are probable to considerably influence on their income and cost creeks after the defence that is afforded by hedging. Banks can sway their exposure to interest rate and exchange rate changes when they proceed as financial intermediaries for their clients. (Collin, 2003, 70)As such, their function as financial intermediaries can sway the sensitivity of their assets and liabilities to interest rate and exchange rate changes. Indeed, an exposure would originate from a mismatch of the bank's assets and liabilities granted in relative to their maturities. (Jimmy, 2007, 90) This mismatch gets tougher to accurately hedge, the more distant the buying into horizon. Finally, the nominal contracting hypothesis has furthermore been used to explain the interest rate sensitivity of banks, granted furthermore the composition of their balance sheet. Since the internationalisation of financial and banking markets is incomplete, it is probable that both interest rate and exchange rate sensitivity would alter amidst FIs and the extent of that variety would count on both the nationality and financial procedures of those institutions. Those risks happen when banks' assets and liabilities are mismatched and interest rate and exchange rate change unexpectedly. Of course, financial organisations can hedge to mitigate some of those risks but hedging tends to be partial or incomplete. (Jimmy, 2007, 90)

A number of empirical investigations have searched to approximate the sensitivity of FIs' stock returns to interest rate ...