Can someone explain why interest rate parity in the economics book (CFAI) is different from the interest rate parity equation in the forwards reading? (both referring to currency) Economics says: F = S*[(1+Rfgn)/(1+Rdom)] Derivatives (Currency Forwards) says: F = S*[(1+Rdom)/(1+Rfgn)] WTF am I missing?
refer to F and S are DC/FC (Derivatives) or FC/DC (Econ)
I had the same question a couple weeks back. thanks for the refresher cp, that is a 1 sentence explanation that clears up a lot of questions.
I guess what Id like to know is how you know how they are quoting it. if you see $1.25 per euro, how do you know what the home currency is? do you just have to remember which section you are being quizzed on?
If we assume a direct quote, which is probably a good assumption if nothing is mentioned, the its quoted as FC:DC, or DC/FC. So if we are given 1.25 per EURO, I woulod assume the DOmestic currency is the , and the foreign currency is the Euro. Either way (i think), as long as you keep the ratios constant (i.e multiply foreign by foreign rates and domestic by domestic rates), you should come up with an accurate forward value. You could always take the inverse of the forward to get the quote from the other perspective.
I totally agree but except for knowing that you are in the Econ or Derivatives section, none of the mock exams or EOC ?s indicate the type of quote. it just gives you $/E and you have to get the forward rate. I would also assume that it is quoted as a direct quote (domestic per unit of foreign), but we know from the Econ section that it is the opposite. Am I missing something here?
TDIGZ Wrote: ------------------------------------------------------- > Can someone explain why interest rate parity in > the economics book (CFAI) is different from the > interest rate parity equation in the forwards > reading? (both referring to currency) > > Economics says: > > F = S*[(1+Rfgn)/(1+Rdom)] > > Derivatives (Currency Forwards) says: > > F = S*[(1+Rdom)/(1+Rfgn)] > > WTF am I missing? The way i treat it is I always use F = S*[(1+Rdom)/(1+Rfgn)]. In economics, if it’s a direct quote :UkPound then Ukpound is the home currency If it's given as UkPound/, convert it to direct and always use the currency to the right side of the dots as local and apply the same formula. When applying the formula F = Spot x (1+rate uk) / (1+rate $) Only one i recall where foreign is in numerator and local is denominator is nominal and real exchange rates where Real = Nominal x Price level f/Price level domestic Try it and let me know if it works for you…
Local currency/forward currency is a poor attempt at explaining basic currency quotes. I ignore it completely. $1.5/euro means just that…it doesn’t matter where in the globe you are located or what your local currenc is , or what your favorite ice cream is. In this equation F = S*[(1+Rdom)/(1+Rfgn)], just replace Rdom by top currency, and Rfgn by bottom currency, in the given quote to match what you are multiplying.
Thanks guys! CP, that makes a lot more sense now. TDIGZ