International fisher effect is one of the five parity conditions that results from arbitrage activities. Arbitrage is the purchase of securities or commodities in the different markets for immediate purchasing and reselling in order to profit from a price discrepancy. The other four parity conditions are the purchasing power parity, fisher effect, interest rate parity, and the forward rates as unbiased predictors of future spot rates. The international fisher effect is the combination of the theory of purchasing power parity and the generalized Fisher effect. The purchasing power parity states that the spot exchange rates between currencies will change the inflation rates between domestic and foreign countries. When the generalized Fisher effect states that the nominal interest rate are a function of the real interest rate. The equation et / eo = (1+ rh)t / (1 +rf ) t shows the relationship between them. “et” is the future spot rate, “eo ” is the spot rate. “rh” is the periodic home currency interest rate and "rf ” is the periodic foreign currency interest rate. “t” is the time period. It states that the interest differential between two countries should be an unbiased predictor of the future change in the spot rate. However, it does not mean that the interest differential is an accurate predictor of the spot rate. This condition means that over time the prediction errors will cancel out. The real rates of interest of the international fisher effect should lean toward equilibrium because of arbitrage. When there is no government interference, the nominal interest rates will vary by the inflation differential. Countries with higher expected inflation rates will have higher interest rates because of the international fisher effect. However, the nominal interest rate differential should reflect the inflation rate differential. The simplified equation of the international fisher effect is rh -rf = (et -eo )/ eo . When the international fisher effect is in effect, the currency with the lower interest rate is expected to appreciate relative to the currency higher interest rate. Source: Shapiro, Alan C., and Atulya Sarin. Foundations of Multinational Financial Management. Custom Edition for California State University, Fullerton. New Jersey: John Wiley & Sons, Inc., 2009.