Solution to Q8, reading 35, Vol.5, page 330. why are we using the Eurocurrency rate to solve of the implied forward rate and not the inflation forecast? how do we know whether to use the interest rate or inflation rate parity relationship?
Purchasing power parity doesn’t work in short term time horizon. We can use PPP (or inflation rate parity as you call it) to form a long-term expectation of a spot exchange rate.
Interest rate parity works at all time horizons. If it doesn’t work - then there is an arbitrage opportunity which will dissapear very fast in liquid markets.
However, you cannot arbitrage-trade on inflation.
thanks!
hi-maybe i’m a little confused with the question. so when we are using the interest rate parity to calculate the forward rate, is the question implying that this rate (derive from IRP) will be the forward rate that the investor can purchase to hedge currency risk?