Chao Wang, CFA, is a portfolio manager looking to take a currency position on the Chinese yuan. The current spot rate is 8.2781 yuan per U.S. dollar, while the two-year forward rate is 9.3336. Wang’s expected holding period is one year. Wang calculates the average expected percentage change in the exchange rate over the next year to be: A 13.46% B -6.18% C 5.68% D -12.75%
(9.3336/8.2781)^1/2 - 1 = 6.184% -> the sign is negative because Chinese yuan is depreciating in value -> B
Respect where respect is due…you guys are in great shape, B indeed. I got confused because it states “average expected percentage change in the EXCHANGE RATE”. Since its yuan/$ and yuan is depreciating, strictly speaking shouldn’t the exchange rate per se increase, i.e. there should be a positive sign for change from now to year 1? Oh well…
Think of premiums and discounts in terms of the denominator, that should help you out. In this case the forward is above the spot and USD is in the denom so the USD is at a premium. Therefore you know the Yuan will be at a discount and is expected to depreciate.
Currency/exchange concepts and q’s are showing up in econ, deriv, pm and an occasional fsa. It is irritating.
Exactly, $ is in the denominator and at a premium, thus, the numerator increases and exchange rate in form of numerator/denominator increases as a whole. Guess I would have liked it more if they referred explicitly to the yuan in the final sentence. Don’t want to stir any more confusion…thanks for the help, though!