If the domestics rate is lower than the foreign rate, and we are given a domestic to foreign translation rate of $.4/Euros…why does interest rate parity say that the forward rate would be lower? What is the logical way to interpret this? Why does a higher foreign risk-free rate imply a lower forward exchange rate?
Spot Rate = 0.4 $ / Euro
Domestic = US, Foreign = Euro
Domestic rate is lower than foreign rate - so there will be a flight to the foreign rate … one way to look at it. invest where the rate is higher.
Another way -> Forward FX rate = 0.4 /Euro \* (1+R) / (1+REuro)
= 0.4 * Lower / Higher = Lower overall… So it will be say $0.38 or so per Euro.
very helpful thanks!