Forward vs spot currency

Hey guys,

If a country increases short/long term interest rates, it increases FDI and thus causes the currency to appreciate.

When calculating the price of a forward, the currency with the higher short term interest rate trades at a premium (i.e. depreciates). Is the simply difference here that in the latter, the real interest rates are assumed to be equal; and th diference in rates wholly attributed to inflation?

Edit* In one of the chapter questions, the interest rates referenced are the risk free rate; which confuses me more because now it’s on th context of real rates

How does higher interest rates increase FDIs?

The forward pricing is the no arbitrage price, it does not nessecarilly mean that real interest rates are equal, nor will the International Fisher Effect unfold.

However, the PPP should hold on the long run, which is a function of relative inflations.

All else equal - if a central bank raises the lending rate in the country, there is an (approximately) equivalent level of risk for higher return, and therefore attracts capital to the country. This results in more demand for the country’s currency, and causes it to appreciate.

If there is an equivalent level of risk for the higher return, then why would demand on invesment in a country increase, and therefore its currency appreciate?

Maybe you’re confusing FDIs with FPI (Foreign Portfolio Investments)

The currency will trade at a forward premium (i.e. expected to appreciate) if it is the low-yielding currency. This is given under the assumption of covered interest rate parity. The logic in the covered interest parity world is that the carry trade will lead investors to borrow in the low-yielding currency to invest in the high-yielding one.

But they’ll eventually need to repatriate their investments, so they lock in the forward rate. Doing so, they increase the demand for their own currency on a forward basis. So their own currency tends to trade at a forward premium. The forward appreciation in their own currrency means that the fx part of their domestic-currency returns will turn negative and will erode the yield advantage from investing in the high-yielding country. It will do so until the domestic-currency return of investing in the high-yielding foreign asset is equal to the domestic return of investing in the domestic low-yielding asset.

Just know that in many cases, CFA assumes an interest-rate parity world and so the key is understanding what happens in this kind of world, however senseless it seems.

This was helpful, thank you. Is the economic driver behind the supposed appreciation in the low-yield currency then just based on the thought that low yield = higher speed economy and thus more demand for the currency, versus a high-yield currency expected to cause the economy to slow down (i.e. US relative to three months ago)


The CFA text makes the relation between the carry trade and the forward rate bias and it is simply saying that if (in terms of P/B where everything referenced towards the base currency) the base currency is trading at a forward premium (price currency expected to depreciate based on abritrage relationship) selling the forward premium currency (base currency) and buying the price currency is the same thing as borrowing the low yielding currency and investing in the high yielding currency. The hypothetical expectation is that the forward price you’ve locked in is a price that is greater than what is expected to happen to the currency and you “sold high” just like selling an equity forward when you expect the price to decline and locking in a higher price. It makes the reference that the currency either depreciates less than implied by arbitrage or it even appreciates so therefore locking in the forward rate provides a profit for what ever may happen to the currency after people either unwind or instability impacts the emerging market currency for which the carry trade was used.

They reference historical observations, I believe.