Hi,
The question is as follows:
According to the uncovered interest rate parity, in 12 months, the JPY/USD exchange rate would most likely be:
Did someone found it weird that the solution seems to use the covered interest rate parity instead of the uncovered formula? I still didn’t get exactly the difference between these two…
Yes, I noticed the same thing.
One is bound by arbitrage and the other is not.
Such a coincidence. I just did this item set 5 min ago. Some questions within this item set use that weird formula. Are they wrong?
There is no formula for _ covered interest rate parity_, nor a formula for _ uncovered interest rate parity_.
There is a formula for _ interest rate parity _. No adjective.
The only difference between covered interest rate parity and uncovered interest rate parity is that the former has a security (a forward or futures contract) that ensures that that formula will hold, while the latter does not. But the formula doesn’t depend on having that security or not; the formula’s the formula.
It’s confusing, because Schweser material seems to differentiate between these two…
According to pg 264 (2017 edition), it shows for each one a formula:
Covered interest arbitrage: F = ((1 + Ra * (days/360)) / (1 + Rb * (days/360))) * So
Uncovered interest rate parity: E(%dS) = Ra - Rb
The application of both in the question above gives us slightly different results - not enough to deviate from the other two alternatives, but still, it is not the same number…
The reason they’re different is that the latter is an approximation.
Interest rate parity is interest rate parity; whether you have a forward agreement in place doesn’t change that.
It really doesn’t make sense this exercise, I mean, also the way they explain the solution…
The same for question 15: covered interest parity, from the theory (even Schweser notes): E(%DeltaS) A/B = Ra -Rb
I would solve it by looking at the difference in interest rates and then this is the chance in the spot rate. They solve it like: Spot x (1+Ra)/(1+Rb)
And what makes me laugh is that in the solution they make a reference on the page of the book where they solved the exercise with the first formula, not the one they used (and leads to different results!)
typical schweser style…
(1+ra) / (1+rb) - 1 = (ra - rb) / (1+rb)
so you could with very small difference say E(%DeltaS) A/B = Ra -Rb -> forgetting the (1+rb) on the denominator.