Interest Rate Parity

CFA Level II Economics
#1

Hi All, IRP for a/b currency pair says Forward = Spot * 1+Ra/1+Rb In the case where Forward > Spot * 1+Ra/1+Rb, the forward is overpriced. Therefore you would sell b (lend at Rb) and buy a (borrow at Ra). (My understanding) Kaplan refers to this situation as money flowing out of the domestic market. My questions are :

  1. Is my understanding of an overpriced forward correct? 2. Does money flowing out of the domestic market means that money is flowing away from dealers portfolios? Thanks for any help. A
#2

Yes. If you’re going to end up with more of currency a than you should, you want to start by borrowing currency a.

I’m not sure that I understand the question. You’re borrowing one currency, converting it to another currency, then investing that new currency. One currency goes out, another comes in.

#3

Thank you S2000. (Was hoping for you to answer)

Regarding question 2, I made the mistake of thinking selling/buying are simultaneous transactions rather than converting first. Many thanks. A

#4

You’re welcome.

#5

Short b in the forward market and buy B in the spot market (by borrowing “a” and converting it to “b” in the spot market)