Forward vs. Spot exchange

CFA Level I
#1

The no-arbitrage forward exchange rate for a Euro in Yen is less than the spot rate. The interest rate in:

I. The eurozone is less than in Japan

II. Japan is the same as the eurozone

III. Japan is less than the eurozone

Could someone explain the rationale behind this? I believe that the yen is expected to appreciate against the euro, but I am a bit hazy as to why lower rates in Japan would help to strengthen the Yen vs the euro? (the answer is C, by the way) Thanks! P.S. if anyone has a good link for an explanation of no-arbatrage trading opportunities, I would love to see it! laugh

#2

I wrote an article on this that may be helpful: http://financialexamhelp123.com/covered-interest-rate-parity-irp-pricing-currency-forwards/.

We’re told that S¥/€ > F¥/€, so

S¥/€ > F¥/€ = S¥/€ × (1 + r¥)/(1 + r€)

1 > (1 + r¥)/(1 + r€)

1 + r€ > 1 + r¥

r€ > r¥

#3

The answer is C . There is an inverse relationship between Exchange rates and interest rates between two countries . Here the euro in forward market is at discount in exchange rate terms and Japan is higher . So In interest rates terms, Japan will be on lower side than the interest rate in euro .This has been explained above also in the earlier post.

Hope It is clear…

#4

Thank you for the explanations, S2000magician and edupristine.

#5

You’re welcome.

#6

Euro in yen is Yen/Euro. I think that’s the trick here.

#7

Can anyone expand on the difference and interpretation of a forward discount vs premium ?

CFAI and schweser describe it a little differently and I’m trying to wrap my head around the idea.

#8

A currency (more broadly, any commodity) trades at a forward premium if its price in the future is higher than its price today.

A currency (more broadly, any commodity) trades at a forward discount if its price in the future is lower than its price today.

For example, if we’re given a spot rate of GBP/EUR 0.8242 and a forward rate of GBP/EUR 0.8305, then the euro is trading at a forward premium (versus the pound): it costs more pounds to buy a euro in the future than it does today. The corresponding rates for EUR/GBP are 1.2133 (spot) and 1.2041 (forward), so the pound is trading at a forward discount (versus the euro): it costs fewer euro to buy a pound in the future than it does today.