covered interest rate parity means that the difference between spot and forward exchange rates equals the difference in the periodic interest rates of the two currencies - fine this makes sense.
But I don’t understand the next two:
The currency with the higher interest rate will trade at a forward discount, F0 < S0
The curency with the lower interest rate will trade at a forward premium, F0 >S0
Shouldn’t higher interest rates mean a premium on the currency?
The USD/GBP spot rate is 1.5425. (I checked.)
Suppose that the 1-year USD risk-free rate is 2.5% and the 1-year GBP risk-free rate is 3.5%. Then the 1-year USD/GBP forward rate is 1.5425 × 1.025 / 1.035 = 1.5276. Thus, GBP trades at a forward _ discount _: you get fewer USD per GBP in the future than today.
For example, if you buy a currency with higher interest rate at forward, say AUD. You should be able to get the AUD at spot (T+2) date and deposit it with higher deposit rate but now the payment delay to forward date. Thus, you deserve a discount for it.
Basically, it’s the difference between two currency interest rate. (one you lend and another one you borrow)
I have two ways to remember this one. Guys please correct me if i am wrong. First method: If interest rates in country A are higher than in country B, country A will attract foreign capital, and the increase in the money supply will create inflation. As a result, the value of currency A will decrease compared to currency B and in anticipation, currency A trades at a forward discount. Second method (absence of arbitrage opportunity but without writing the formula): Interest rates in country A are higher than is country B. Suppose you have cash in currency B. If markets are efficient i.e. there is no arbitrage opportunity, you should get the same return from 1) investing your money in country B and converting it at the forward rate at the end if the period 2) Converting it at the spot rate and investing in country A at the beginning of the period. The two returns can only be equal if you get a discount on the exchange rate at the end of the period, i.e. if currency A trades at a forward discount. All if this being said, i think it’s probably easier to remember the formula that results from the absence of arbitrage opportunity…
sincere advice: Please pick up Level II CFAI text and read the first chapter, I can understand the source of confusion. Especially focus on the following: 1: CIP and UIP are 2 CURRENCY world. interest rate differential will lead to currency depreciation of higher yield: 2 EFP and EMP are Government.s DELIBERATE intervention which boost currency value at lower interest rate by making the economy work. Only deliberate intervention would count here. 3. Taylor’s rule on why on a REAL interest rate increase the higher yielding currency should appreciate. last 2 don’t consider 2 currency world but a truly globalised picture. Carry Trade is the lacuna of O1st theory not holding. Economics is fun but requires effort.
Interest rate parity and supply/demand for currency are two separate effects, and they generally work in opposite directions. Don’t conflate them.
Thanks for the tips. As a matter of fact i remember forex topics were very clear to me after reading level ii material, and with level iii material i get totally confused
I’m dredging this up from a few weeks ago.
In your post you refer to the rate as “USD/GBP.” By convention, this rate is quoted as GBP/USD, like EUR/USD but unlike USD/JPY. I trade these currencies at work often.
Here’s GBP/USD: http://finance.yahoo.com/q?s=GBPUSD=X
Why are you reversing the numerator and denominator in your post? Is this a CFA thing I’ve forgotten in the years since I last took L3?
Yes, it’s a CFA thing.
Nothing we can do about it.
When they mean USD1.5425 = GBP1.0, they write USD/GBP 1.5425.
Just to add to the quoting convention discussion, the cirriculum does say that they use P/B notation with the the heirarchy being GBP, Euro, USD quoted as the base currency. They do mention, I believe, that futures in the CME are usually the opposite of this with the USD being quoted as the base.
I think F0 < S0 is error. forward discount means F0 > S0 in price(high i)/base(low i) convention. except that equation, every other concepts are corrected.
The CFA convention - the exam we are talking about - not the outside work
USD/GBP = 1.2 in spot 1 GBP = 1.2 USD
USD/GBP = 1.5 in fwd 1 GBP = 1.5 USD
GBP is at a premium if fwd mkt - you get more USD
USD is at a discount