The International Fisher Effect is an economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries' nominal interest rates for that time.

The rational for the International Fisher Effect is that a country with a higher interest rate will also tend to have a higher inflation rate. This increased amount of inflation should cause the currency in the country with the high interest rate to depreciate against a country with lower interest rates.

This theory is also known as the assumption of Uncovered Interest Parity. According to the generalized Fisher effect, the real interest rates should be same across the borders. But the validity of generalized Fisher effect largely depends on the integration of the capital market. That is, the capital in the market needs to be free to flow across borders. Usually the capital markets of the developed countries are integrated in nature. It has been seen that in the underdeveloped countries the currency flow is restricted.

The theory is calculated by the following formula:

E = [(i1-i2)/(1+i2)] ? (i1-i2)

Where:
E represents the percentage change in exchange rate
i1 represents the interest rate of country A
i2 represents the interest rate of country B

An example that may help to understand the value of the theory: if the interest rate of country A is 10% and that of country B is 5%, then the currency of country B should appreciate roughly 5% compared to the currency of country A.

The International Fisher Effect also estimates the future exchange rates based on the nominal interest rate relationships. The estimate of the spot exchange rate 12 months from now is calculated by multiplying the current spot exchange rate by the nominal annual U.S. interest rate and then dividing it by the nominal annual British interest rate.

References:

Maps Of World.Com, International Fisher Effect, Last viewed December 13, 2009, mapsofworld.com

Investopedia, International Fisher Effect-IFE, Last viewed December 13, 2009, investopedia.com