Impact of Interest Rate Differentials on Currency Risk

Very Hard Currency Management Currency Risk Factors

A global investment firm manages a portfolio that includes various international equities. Recently, there have been volatile fluctuations in the currency exchange rates affecting their overseas investments, particularly in Emerging Market economies. The firm seeks to implement a robust currency risk management strategy to mitigate potential losses associated with adverse currency movements.

One of the key risk factors they are analyzing is the impact of interest rate differentials between domestic and foreign countries. Considering the relationship between currency values and interest rates, which of the following statements best captures the primary influence of interest rate changes on currency risk?

Higher domestic interest rates typically lead to currency depreciation as foreign investors seek higher yields elsewhere.

A narrowing interest rate spread between the domestic and foreign currencies tends to strengthen the domestic currency due to increased capital flows.

Increased interest rates in foreign countries create stronger demand for foreign currencies, resulting in a depreciation of the domestic currency.

Hint

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