I understand that Forward rate bias is the same as carry trade, but I can’t get my head around it using the logic below:
Covered IRP: F/S = (1+rx)/(1+ry); quoted as X/Y, Y is foreign currency.
If: F/S > (1+rx)/(1+ry), doesn’t it mean that Currency Y has forward premium? Forward rate bias states that we sell currencies trading at a forward premium. So in this case, why don’t we sell Y and buy X? The correct answer is to sell X and buy Y.
BRL/AUD spot rate: 2.1131
BRL/AUD forward rate: 2.1392
BRL 1-year interest rate: 4%; AUD 1-year interest rate: 3%.
F/S= 2.1392/2.1131= 1.01235
(1+Rbrl)/(1+Raud) = (1+4%)/(1+3%) = 1.00971
Thus F/S > (1+Rbrl)/(1+Raud)
I would think AUD is trading at a forward premium, thus we should sell AUD and buy BRL. But the correct answer is to short BRL. I feel that I got something fundamentally wrong. Could someone please help? Thanks!