Hi all, got a quick question about a sentence on page 238 in Schweser book 2, LOS 21.h “Calculating the arbitrage-free forward exchange rate.”
Higher interest rates = appreciation, right? Intutively this makes sense because a higher rate of return on a particular currency increases demand for that currency, causing appreciation. That said, what is going on in this example? Particularly the last sentence, which i’ve bolded, makes no sense to me. I’ve copied the example it below:
Consider two currencies, the ABE and DUB. The spot ABE/DUB is 4.5671. ABE interest rate is 5% and DUB interest rate is 3%.
what is the forward XR that will prevent arbitrage?
ANSWER :
Forward = spot * (1+iabe)/(1+idub)
Forward = 4.5671 * (1.05/1.03) = 4.6558
Note that the forward rate is greater than the spot rate by 4.6558/4.5671 - 1 = 1.94%.
This is approx equal to the interst rate differential of 2%.
The currency with the higher interest rate should depreciate over time by approximately the amount of the interest rate differential.
Wrong. Higher interest rates lead to depreciation (through interest rate parity).
Interest rate parity and economic supply/demand forces generally act in opposite directions: when IRP causes appreciation, demand for the currency will decrease, causing depreciation, and vice-versa. The forward rate formula accounts only for IRP.
It’s correct: higher interest rate leads to depreciation (via IRP).
Hi, I had a problem with that too . Think of it in two ways. Using the IRP formula, it’s easy to understand why an increase in interest rate leads to a depreciation. In your case, dub appreciated which means abe depreciated.
The comment regarding the the higher interest rate leading to higher demand and appreciation only refers to REAL INTEREST RATES. I think the IRP formula uses nominal interest rates. If indeed real interest rate rises, then demand should cause an appreciation. That’s how I rationalised it.
BTW, how are you progressing, I am taking Level 1 in June too.