“An investor’s home currency has a risk-free interest rate of 7%. A foreign country has a risk-free interest rate of 3%. The current exchange rate between the two countries is 2.00(DC/FC), and the expected spot rate in one year is 2.10. Calculate the hedged expected return.” So I know that the hedged expected return is equal to the foreign interest rate plus the forward premium on the FC, but the book says that the forward premium on the FC is equal to the interest rate differencial of 7%-3%=4%. Why is that? Why is the difference between interest rates NOW equal to the forward premium (“forward” implies at a later date, yet these currencies only give you a SPOT-RATE DIFFERENTIAL of 4%.
read as expected spot (E(s1)?
a:b convention F = S (1 + rb)/(1+ra) Add -S to both sides F - S = S(1 + rb) / (1 + ra) - S F - S= S ((1+rb)/ (1+ra) - 1) (F - S) / S = (1 + rb)/ (1 + ra) - 1 (F - S)/S = ((1 + rb) - (1 + ra)) / (1 + ra) (F - S)/S = (rb - ra) / (1 + ra) (F - S) / S = forward premium Forward premium = (rb - ra) / (1+ra) Forward premium * (1 + ra) = rb - ra Am I on the right track here?
Hmmm interesting. So I can find the forward rate by taking (1+domestic rate)/(foreign rate-domestic rate)? -Richard
(domestic rate - foreign rate) / (1 + foreign rate) In your case, DC/FC is equal to FC:DC, so a = FC, and b= DC