Question

You are having a conversation with your European business partner. She tells you the EUR fixed interest rate for 5 years is 1% and is shocked when you inform her that in Australia the 5-year fixed rate is 3.5%. Your 5-year estimate for the EUR inflation rate is 1% and for Australia 3%.

(A) You ask your business partner if she can give you any hints how to get a mortgage in Europe to refinance your Australian house.

(B) Adding inflation to the rates they are 1%+1%=2% in Europe and 3.5%+3%=6% in Australia. Therefore, you are even more shocked than your business partner.

(C) You tell your business partner that the economic conditions differ and that the real interest rates are much more similar.

(D) You tell your business partner to borrow as much as possible in Europe and to use the money to buy Australian government bonds, which have a risk free return of some 3%.

Answer 1

The correct answer is option C i.e. You tell your business partner that the economic conditions differ and that the real interest rates are much more similar.

All other factors being equal, higher interest rates in a country increase the value of that country's currency relative to nations offering lower interest rates. However, such simple straight-line calculations rarely exist in foreign exchange. Although interest rates can be a major factor influencing currency value and exchange rates, the final determination of a currency's exchange ratewith other currencies is the result of a number of interrelated elements that reflect the overall financial condition of a country in respect to other nations.