FX (IRP)

Assume the spot exchange rate for Polish Zloty (PLN) to the dollar is 4.10 PLN/USD and the one-year forward rate is 4.15 PLN/USD. If interest rate parity (IRP) holds, and the one-year US interest rate is 1.5%, the Polish 1-year interest rate is closest to: A. 0.28% B. 1.0% C. 2.74% D. 3.15%

C

So, if forward Zloty is trading at a discount to spot Zloty, Zloty interest rate MUST be less than USD interest rate?

should be A… F/S = (1+rd)/(1+rf) 1,012195 (1+rf) = (1,015) (1+rf) = 1,002771 = 0,28%

Pico, I believe the PLN is assumed to be the domestic currency in this problem.

Pico, that is what I thought, but evidently it’s C.

c for me too 1+rd=1+rf *fwd/ spot where fwd and spot expressed as dc/df and rd interest rate domestic

finance03 Wrote: ------------------------------------------------------- > So, if forward Zloty is trading at a discount to > spot Zloty, Zloty interest rate MUST be less than > USD interest rate? More than USD interest rate. Agree with Miu - answer is 1.015*4.15/4.1 = 1.0274

Is the reasoning for this because the Zloty is trading at a forward discount, it must have a higher interest rate to compensate for the discount, otherwise arbitrage exists?

moto376 Wrote: ------------------------------------------------------- > Pico, I believe the PLN is assumed to be the > domestic currency in this problem. This makes no difference as the zloty interest rate is the same whether or not you live in Poland. If the currency is expected to depreciate then they gotta give you more interest for putting your money there. These IRP things are really that simple.

finance03 Wrote: ------------------------------------------------------- > Is the reasoning for this because the Zloty is > trading at a forward discount, it must have a > higher interest rate to compensate for the > discount, otherwise arbitrage exists? YES!

yeah, you guys are right… Forward = DC/FC Spot = DC / FC so Polish must be domestic…

Great, so then how does this reconcile with higher yielding currencies demanding a premium to lower yielding ones? This is the source of my confusion…

finance03 Wrote: ------------------------------------------------------- > Great, so then how does this reconcile with higher > yielding currencies demanding a premium to lower > yielding ones? This is the source of my > confusion… It’s a premium NOW relative to later. If I’m going to get 25% interest in some currency, then I gotta pay up for it now, knowing that it will depreciate.

it’s pretty logic if irp holds and we know that the us dollar will appreciate relative to the polish currency then it makes sense that us would offer a lower interest rate than the polish one

In fact, it’s more than that because this is covered interest arb so it has to hold.

C. Finance 03, Since PLN is trading at a discount, its interest rate MUST be MORE than USD interest rate (since it’s giving u more interest, it’s expected to depreciate relative to USD which gives u a smaller interest if the IRP holds).