Economics Question- Reading 14 Example 6

CFA Level II Economics
#1

In example 6

Q1) I thought Covered Int parity was bounded by arbitrage, so covered int parity is an arbitrage condition

Q4) shouldnt the asnwer be uncovered Int rate parity. I thought the prediction of the spot rate was due to the interest rate deferentials under the Uncovered int rate parity

Any help clarifying these would be helpful. Thanks

#2

I haven’t a copy of the curriculum, so I don’t know the questions being asked (nor the data given), but . . .

Correct. It is the addition of the forward contract that completes the arbitrage transaction (cash-and-carry, or reverse cash-and-carry).

The forward rate is an unbiased estimator of the future spot rate, and the forward rate is (roughly) today’s spot rate increased by the interest rate differential. (It is exactly today’s spot rate compounded/discounted by the rates for the numerator (price currency) and the denominator (base currency) respectively.)

I hope I added some value.

My pleasure.

(If you can post some of the details on the questions (without violating CFA Institute’s copyright), I may be able to help a bit more.)

#3

Thanks for the info. However, the questions are as follows:

  1. Which of the following is a no-arbitrage condition

a) Real Interest rate parity

b) Covered Interest Rate Parity

c)uncovered interest rate parity

Book answer : B

  1. The forward premium/discount is determined by nominal interest rate differentials because of

a) Fisher Effect

b) covered interest rate parity

c) real intrest rate parity

Book answer: B

I believe both answeres should be uncovered int rate parity . Can you shed light on this ? Thanks

#4

I guess i was wrong for part 4) for uncovered int rate parity Its the depreciation/appreciation of the spot exchange rate that equals the differentials

but for 1) Covered int rate parity is bounded by arbitrage

#5

Correct: covered interest rate parity prevents arbitrage. Real interest rate parity ignores inflation differentials which are essential in computing forward rates, and uncovered interest rate parity may or may not hold; the only thing that would prevent arbitrage is an agreement today on the future exchange rate: that’s covered IRP.

Remember what arbitrage is: riskless profit. To be riskless, you have to enter into all of your transactions today. In uncovered IRP you’re waiting until the future to see what the spot rate will be, hoping that it will earn you a profit; that’s not riskless.

(Note: what I wrote about entering into all of the transactions today isn’t strictly necessary – the arbitrage transactions with an FRA would be an example – but I didn’t exaggerate too much.)

Correct: the forward rate (from arbitrage, ensured by covered IRP) is determined by the differences in nominal interest rates. The Fisher effect combines the real interest rate and the inflation rate to get the nominal interest rate, and real interest rate parity ignores inflation differentials which play a role in exchange rates.

Still?

I hope that I did. Let me know if I fell short.

You’re welcome.

#6

Thank you sir. That helped

#7

My pleasure.

Glad to hear it.