Can anyone help me on this trivial question: This is what one of the schweser answers stated: “If the forward rate is lower than what the interest rate parity indicates, the appropriate strategy would be: borrow pounds (foreign), convert to dollars (domestic) at the spot rate, and lend dollars (domestic).” I thought it was the other way around if the forward rate is lower, ie borrow domestic, lend foreign? Many thanks…
LHS = f/s = (1+I_{D})/(1+I_{F}) = RHS Suppose LHS < RHS (forward rate is smaller than IRP), then: (1/LHS) > (1/RHS) s/f > (1+I_{F})/(1+I_{D}) (s/f) x (1+I_{D}) - (1+I_{F}) > 0 This inequality translates to: borrow from foreign (because of minus (1+I_{F}), convert at spot rate, invest into domestic to earn interest (plus (1+I_{D})) and then convert back at forward rate. So you want to enter into a forward contract that let you sell the domestic currency at fixed rate (sell a forward contract as the short side). I’ll leave the other case (forward rate is larger than IRP) as an exercise.
eltia Wrote: ------------------------------------------------------- > LHS = f/s = (1+I_{D})/(1+I_{F}) = RHS > > Suppose LHS < RHS (forward rate is smaller than > IRP), then: > > (1/LHS) > (1/RHS) > s/f > (1+I_{F})/(1+I_{D}) > (s/f) x (1+I_{D}) - (1+I_{F}) > 0 > > This inequality translates to: borrow from foreign > (because of minus (1+I_{F}), convert at spot rate, > invest into domestic to earn interest (plus > (1+I_{D})) and then convert back at forward rate. > So you want to enter into a forward contract that > let you sell the domestic currency at fixed rate > (sell a forward contract as the short side). > > I’ll leave the other case (forward rate is larger > than IRP) as an exercise. Thanks Eltia that helped…