CFA book Reading 19 Q#1, Consider two countries, home country A and B, whose currencies are alpha and beta, respectively. The interest rate in A is greater than the interest rate in B. Which of the following is true? 1. alpha is expected to appreciate relative to beta, and alpha should trade with a forward discount. 2. alpha is expected to appreciate relative to beta, and alpha should trade with a forward premium. 3. alpha is expected to depreciate relative to beta, and alpha should trade with a forward discount. 4. alpha is expected to depreciate relative to beta, and alpha should trade with a forward premium. CFA book answer is 3. How??? A’s interest rate is higher than B, then A currency should appreciate.

Forward / Spot = (1+rd) / (1+rf) assume direct quotes (dc = alpha) if Rd = 5%; Rf=3%; Spot Rate = 1 (a) / 1(b) solve for Forward rate: F = 1.02 so at the spot rate, 1a = 1b at the forward rate, 1.02a = 1b b has a forward premium and will appreciate (it will be worth .02 more of a), therefore a will depreciate

If this wasn’t the case, one could profit by borrowing b, investing in a, and converting back to b with a risk free arb profit. Also, the interest rate listed here is the nominal interest rate not the real interest rate.

Thanks, I never thought of PPP here.

yea you’re right 3 is correct.

Answer 4 doesn’t make sense If alpha is expected to depreciate (due to higher nominal int rate) it will trade at fwd disc, not prem

Alpha must depreciate relative to beta. For example, if the interest rate in Canada was 20% and the US interest rate was 5%, then Americans could borrow dollars, convert them to Candian dollars, invest for 1 year and earn a 20% return and then convert them back to US dollars. The Canadian dollar must trade at a forward discount to prevent the US investor from locking in arbitrage profits using a forward contract.

these questions are helping me a lot - good source of some thinking … thanks guys! kg

This can also be thought of as Alpha needs to offer a higher interest rate to compensate for the depreciation of the currency.

cfano1 Wrote: ------------------------------------------------------- > Thanks, I never thought of PPP here. Which is good because this is interest rate parity not purchasing power parity.

i understand that the answer makes sense in terms of interest parity relations, but can anyone explain this in terms of supply and demand? I got caught by this question because I thought that A will appreciate since the demand for the currency will be high because of the higher interest rate.

A higher real interest rate will bring an increased demand for USD, an increase in nominal interest rates might not. If the increase in nominal rates is due to inflation, the real interest rate could be the same or lower than it was previously.

TY