I’d appreciate any input… 1. What’s the difference between “forward rates” and “expected future spot rates?” Both have the same formula, and both seem intuitively the same to me. 2. What’s the difference between covered and uncovered interest rate parity? I know what the difference is as per definition (arbitrage relationship holds with covered but may not hold with uncovered because the future spot rate is not known), but I’m not sure if I really grasp this. Can someone kind of dumb it down for me so it can be more intuitive? 3. How come expansionary monetary policy leads to lower real interest rates, but expansionary fiscal policy leads to higher real interest rates? Is it because expansionary fiscal policy leads to spending deficits, which leads to a crowding-out effect? Thank you all for taking the time to look at my questions!
i’ll do #3 since it is the hardest, u can delve deeper into google for the answers in 1 and 2. 3. expansionary policy implies the money supply (MS) goes up. it means the Fed is increasing the money supply by buying the bonds from the open mkt. MS goes up, bond supply goes down, bond prices go up, bond interest rates go down.
pacman, Thanks for your explanation. This was the part that I DID understand–I was confused as to why fiscal expansion was the opposite (interest rates went up, not down). Can anyone help explain this in more detail? What about the first two questions? Thanks.
Expansionary fiscal policy implies that the Govt. will undertake deficit spending. This will be financed through debt issues which will boost rates due to the “crowding out” effect. Basically you had the right idea, but I just felt like typing it out to cement it in my mind
I’m having trouble with the parts 1&2, too. Please let me know if you eventually find a “dumbed-down” explanation. (I’ve also been searching for one)… Good luck in the meantime.
- What’s the difference between “forward rates” and “expected future spot rates?” Both have the same formula, and both seem intuitively the same to me. I would say forward rates, is referring to forward rate agreements, whereas expected future spot rates is talking about your projection for the spot rate at some point in the future. It makes sense that they would have the same formula, since a forward rate agreement is a contract that helps you invest based on your particular beliefs about the spot rate at some date in the future.
1 and 2 are related, according to the Schweser videos. The simple answer given was that #2 covered interest rate parity is a tradable idea, uncovered is a theory. I think the same could be said for #1, forward rates are tradable, expected sports are not.
I’m watching the Allen Resources videos and they confirm that the Forward Rate is a contractual rate for future delivery, while the Expected Future Rate is the spot rate in one period.
for parity relations to be unbiased, the forward rate is equal to the expected spot rate. Otherwise, there is an arbitrage opportunity.
"1. What’s the difference between “forward rates” and “expected future spot rates?” Both have the same formula, and both seem intuitively the same to me. " They are different, and no, they do not have the same formula. To clarify, understand that sport and forward markets are separate markets. As an example, take for instance, crude oil. The spot market is the market where people who need oil today (say, refineries) go and buy it. Let’s say spot price is at $100/bbl - so that is the current spot price. The forward market might be, for instance, the NYMEX futures market where hedgers and speculators trade futures contracts. Let’s say the forward price for delivery one year from now is $110/bbl. So that is the current forward price. These two prices are observable in the market. But what is the expected price of crude one year from now? That is unobservable and everyone has their own opinion. On aggregate, we can try to figure out what the collective opinion of the market is from the forward rates. Is it $110/bbl? Or is it more than $110/bbl or less than $110/bbl? Now, we know there is a relationship between spot price (NOT expected future spot rate) As long as there is enough arbitrageurs and capital around, this relationship will hold. But that relationship is not based on where we think the price will be one year from now. It is based on the current spot price, the current risk free rate (or, more precisely, the arbitrageurs funding rate) and the yield of the underlying commodity (zero for crude). So while the forward price is $110/bbl, that has nothing to do with what people think about the price one year from now. Theory says that the expected spot price will be the same as the forward price if the price of the underlying is uncorrelated with the stock market (i.e., your required rate of return on investing in the futures would be the risk free rate), higher than the forward price if the underlying is positively correlated with the stock market (e.g., stock index) and lower than the forward price if the underlying is negatively correlated with the stock market (e.g., gold). It is easy to explain why, if anyone is interested.