I understand that a country’s currency (1) will appreciate if it has a higher real interest rate (2) will depreciate if it has a higher nominal interest rate My question is, if a country has both a higher nominal interest rate and a higher real interest rate, what’ll happen to its currency? Thanks.
This depends on what is the driving the growth in the nominal rate. If the nominal rate is growing due to the fact that the real interest rate is increasing (and not inflation), the the currency will rise. If the main driver is inflation, then it will depreciate. (This is assuming no PPP) However for the exam I am going under the assumption that they would tell you why this is (such as a International Fisher examples) where they would assume equal real rates across borders.
Thanks a lot. Now I have another question. in Schweser notes book 2, page 77, problem 9 and problem 10. In problem 9, obviously A is correct answer, however, why C is wrong? Is it only because of the word “premium”? in some cases it could be “discount” rather than “premium” In problem 10, what if I give you another choice: 4.304%, would you still choose A 4.25%? How did I get 4.304%? (1) assuming current exchange rate is 1E, forward discount of 1.25% means 98.75%E (2) 1.03/(1+?)=98.75% (3) ? = 4.304%
June2010 Wrote: ------------------------------------------------------- > Thanks a lot. Now I have another question. > > in Schweser notes book 2, page 77, problem 9 and > problem 10. > > In problem 9, obviously A is correct answer, > however, why C is wrong? Is it only because of > the word “premium”? in some cases it could be > “discount” rather than “premium” I believe it is because the question states that there is an arbitrage opportunity. If “the interest rate differential is approximately equal to the forward premium” then it is assuming the markets are efficient. > > In problem 10, what if I give you another choice: > 4.304%, would you still choose A 4.25%? > > How did I get 4.304%? > > (1) assuming current exchange rate is 1E, forward > discount of 1.25% means 98.75%E > (2) 1.03/(1+?)=98.75% > (3) ? = 4.304% 4.304% is correct, however there is the exact method of calculating IRP and there is the linear approximation. Using the linear approximation method of f = rb - ra we get -1.25 = 3.00% - 4.25%. If there was another answer of 4.304%, that would be more correct. Best, TheChad