EOC 6 question B, from reading on “fixed income portfolio Management - Part II”
Dollar/Euro spot rate 1.21
1 year deposit rate:
Euro 3%
Dollar 2%
Considering interest rate parity, the forward exchange discount should be (1+2%)/(1+3%) - 1 = 0.97%
(the question actually does not ask for the discount but for the forward rate, but to come to the result the above formula is used to compute the discount).
My question is the following:
In the course, they say that the forward rate discount / premium is approximately Id - If (domestic and foreign risk free rates) which in the context of the above question would have given us a discount of 1% which very close to 0.97%.
Can we use Id - If to answer a question or do we also have to use (1 + Id) / (1 + If) -1 ?
I remember having seen the formula Id - If used in one EOC but I can’t find it anymore.
I mean, of course if it’s a multiple choice, since it is really approx. the same, I would not hesitate to take the shortcut. I am asking regarding the morning session…
Do it the correct way; don’t use the approximation.
Actually it seems that the curriculum uses the shortcut quite often in the EOC, for example in this very typical question:
“Home country has a short-term interest rate of x%, foreign country of y%. Should you hedge foreign currency if it is expected to appreciate by z%.”. And the answer is always to compare z with x - y.
I am just wondering if, in a more detailed question where they ask for a forward rate to be computed and so on, if they would penalize a candidate using the short formula.
Talking in a related subject, should the roll yield equal 0 at maturity date of the forward conract? since the F should = S at maturity