I’m having some confusion with the wording of a question on foreign exchange. The question from book 2 of Schweser, page 191, question 13 says: Assume the Philippine peso is at a 1-year forward discount rate of 1.25% to the Thai baht and that Thailand’s 1-year interest rate is at 3.00%. If a Thai investor has no arbitrage opportunities, the Philippine interest rate is closest to: A. 3.10%, B. 4.25%, C. 1.76% or D. 1.25% (Ans: B.) When the question states “the Philippine peso is at a 1-year forward discount rate of 1.25% to the Thai baht” are the units in peso/baht or baht/peso? I know the question is relative to the Thai investor, so I would think that I need the units to be baht/peso, but the wording just really confuses me. Any clarification would be appreciated!
The problem is that there really aren’t units and you should just think about that sentence as nearly a normal English sentence. The peso trades at a discount to the baht means that you get peso cheaper in a year in the same way that “shoes are on discount at Talbots on Columbus day” means that shoes will be cheaper on Columbus day. The question isn’t “relative to a Thai investor”; it’s to anyone. An equivalent sentence is “The Thai baht trades at a 1-year forward premium to the Philippine peso…”
let Ih be the interest rate in the country yield a higher rate and Il be the interest rate in the country yield a lower rate. Covered interest parity says that the exchange rate of the country with higher rate will fall relative to the country with lower rate. So Ih’s currency will be trading at a forward discount. Ih + fp = Il where fp is the forward price of the ccy ( which will be trading at a discount ) In our case, we know that the peso is trading at a disc of 1.25. This means that peso has higher interest rate now. so, Phillipine int rate - fwd disc = Thai int rate Phillipine int rate - 1.25 = 3 => Phillipine int rate = 4.25% the question could probably have be phrased in a diff way: "thai bhat is trading at a forward premium of 1.25% " hope this helps.
I was wondering, how would you solve this problem using the interest rate parity equation?