Short-term (one month) goverment rate in canada is 1.9%, UK is 5%.
Which currency expected to be comparatively stronger?
UK rates are higher, so investors would invest in UK which would drive up currency value
It s what CFAI says…
What happen if i am a canadian invester, short CAD T-bill to get C$, exchange to P on spot rate, buy a UK bill to get 5% interest and then exchange back to C$ at higher rate ?
^ that is exactly why UK rate gonna be higher.
when you first short CAD, you put more downward pressure on CAD, and upward pressure on UK
you’d make money. which is why it would be arb’d out in the forex market as soon as the opportunity presented itself
Is there a conflict with interest rate parity ?
you will do the above if and only if the forward rate implies C$ is undervalued.
ie: F = 1.78 C$/P when interest rate parity implies F = 1.75 C$/P (hypotethical numbers)
You borrow C$ @ 1.9%, exchange at spot (say 1.80C$/P) for P, lock-in P @ 5%, Short a forward contract to deliver P for C$ at 1.78 C$/P
Comes maturiy, assuming interest parity holds true, you get your arbitrage profit by selling P at 1.78 instead of the new Spot at 1.75.
Any thoughts?
What i thought when saw the question is that:
horizon is short (one month), and both interest above is risk free…
So the interest rate parity theory should be followed other than capital flow theory…
I agree that the currency will be stronger if there is higher long-term real interest rate (follow the capital flow theory)
The IRP theory says P will be weaker …
any miss ?
1, IRP is used to price the forward exchange rate. If it holds, no arbitrage opportunity. It’s not a forecasting tool.
2, When the short term interest rate is higher, the demand for the currency will rise. So the currency appreciates in the short term. In the long term, PPP, growth, cash flow and savings/investment imbalance can affect the currency value.
Thank guys,
I got it by this way.
Assume initial spot rate is 1:1, forward 1 month also 1:1 and the interest rate above is monthly
Arbitrators jump in to short C$ and the (spot) rate will sharply decrease to 1.0304C/P to let the arbitrate opp disappear…
is that what the market work ? (and IRP tells us?)