Domestic risk free = 4%; Foreign risk free = 4.8% Fwd differential = -0.8%, which means foreign currency is expected to depreciate by 8%. Example on page 208 of Schweser Note Bk3. Shouldn’t foreign currency be expected to appreciate? Since foreign rate is higher, investors would want to invest in foreign, thus demanding more foreign currency. Can somebody explain? Thanks.
The statement from Schweser is correct. Currency with smaller interest rate is expected to appreciate due to uncovered interest rate parity.
sleepybird Wrote: ------------------------------------------------------- >. > > Shouldn’t foreign currency be expected to > appreciate? Since foreign rate is higher, > investors would want to invest in foreign, thus > demanding more foreign currency. Can somebody > explain? Thanks. Higher foreign rate could be due to inflationary effect and real effect. If the rate in question is real rate, then your argument is correct.
maratikus Wrote: ------------------------------------------------------- > The statement from Schweser is correct. Currency > with smaller interest rate is expected to > appreciate due to uncovered interest rate parity. Except here, they give you the forward differential (which I suppose is about FX forwards not the implied differential) so it is covered interest rate arb. Sleepybird - you should understand the arbitrage which is all about how FX forwards are priced. The FX forward is just priced according to how market particpants can buy and lend money in eaach currency and has nothing to do with how people feel about investing in either country.
Joey, you are definitely correct about explaining covered arbitrage. However, in the above example they conclude about appreciation/depreciation of currency based on interest rate differential. That relationship is explained by uncovered interest rate arbitrage.
Yep…
Thanks.