I am having a really hard time staying consistent with my FC:DC notations here. Given different FX quoting conventions I am mixing up which currency is foreign and which is domestic. This complicates which interest rate/inflation rate I use in the numerator and demoninator for the various parity equations.
Anyone have a nice little trick to keep this stuff straight?
Thank you.
For interest rate Parity, the Formula notation on page 639, equation 1 states “S and F” are quoted as “DC:FC”. F/S = (1+r_fc)/(1+r_dc). This is opposite the a:b (FC:DC) convention for a direct quote. Follow question 4, Reading 18. I find it very confusing as well. Pls respond if you find this to be accurate and helps.
I think interest rate parity was the most confusing bc, as you stated, it seems to be portrayed opposite the way currency rates were introduced and used throughout the reading (direct quote = FC:DC). The others seemed ok. I too found them confusing, and still do somewhat, but i realized two things that should help: i) be consistent on both sides of the equality - the currency and rate should match in the numerator and denominator. ii) try not to worry about the order: direct vs indirect, who’s foreign vs domestic. I know that’s instinctive but you should be able to tell which interest rate or inflation rate goes in the numerator based on which currency you expect to depreciate / appreciate according to the parity (question) you’re following (answering). For example, if one country has higher nominal rates than another, than you should expect that currency to depreciate if IRP holds. Then just put the appropriate rate in the numerator / denominator depending on the answer the question is looking for in order to derive future appreciation or depreciation. That order should match the order of your spot or fwd rate. That’s at least the way i finally had to think about it, hope it’s clear. Trying to follow who the domestic country is and remembering a:b (esp since a:b seemed to be presented oppositely for IRP) became too confusing and i just never quite figured it out. Hope that helps.
LOS states Calculate End of Period XRATE, given the BOP XRATE AND Inflation rates. s0[1+I_DC/1+I_FC]^t, FC:DC spot if DC:FC, formula is reciprocal. EITHER way, it is b/a, depending on spot form.
I thought that you just put whatever currency the rate is quoted in, in the numerator? ie if it is EUR:USD = $1.25, because the quote is expressed in USD, the US interest rate goes in the numerator. Would appreciate it if someone can correct me if I am wrong on this! Cheers
that is correct. their nomenclature is DC:FC, a:b, and the b is in the numerator, b/a.
So would everyone agree that a consistent way to attack this issue is to put whatever currency is quoted in the numerator? Does this apply to cross rate calculations as well?