Chartered Financial Analyst (CFA) Practice Exam Level 2

How does the expected depreciation of a currency relate to its interest rate?

1. A currency with lower interest rates is expected to depreciate

2. The currency’s depreciation is independent of interest rates

3. A currency with higher interest rates will likely appreciate

4. All currencies behave similarly regardless of interest differential

The correct answer is: A currency with lower interest rates is expected to depreciate

The relationship between a currency's expected depreciation and its interest rates is grounded in the principle of interest rate differentials and capital flows. When a currency has lower interest rates, it typically yields less return for investors compared to currencies with higher interest rates. As a result, capital tends to flow out of the country with the lower yielding currency in search of better returns elsewhere. This outflow increases the supply of the lower yielding currency in the foreign exchange market, leading to its depreciation. Furthermore, lower interest rates may signal lower economic growth or reduced inflation expectations, which can make that currency less attractive to foreign and domestic investors alike. Therefore, expectations of depreciation align closely with lower interest rates, supporting the idea that a currency with lower interest rates is indeed expected to depreciate. In contrast, higher interest rates usually attract foreign investment, as investors seek to capitalize on higher returns. This influx of capital can lead to an appreciation of the currency. The other choices either ignore these fundamental relationships or misstate their impact on currency valuation, making the first choice the most accurate in reflecting the dynamics between interest rates and expected currency movements.