In this question the domestic currency is Euro (german) and foreign is UK (pounds). id = 2.5% and if = 3.25% and strategist forecast that the euro will depreciate .35%.
HR = Rl + id - if = Rl + 2.5 - 3.25 = Rl + 0.75%
UHR = Rl + 0.35%
W hy are they using 0.35% here? The form is supposed to be D/F or the percentage change of the foreign currency. This is the percentage change in the domestic currency. 0.35% euro depreciation is not the same as a 0.35% UK appreciation which is in the equation.
Or when doing this questions, do we not carry for it to be that specific? Exact numbers with these changes?
Thanks…much appreciated…
I think they key point to remember here is the following.
Forward prices already include IRP and thus interest rate differentials. If IRP and thus forward markets price in 0.75% appreciation of GBP, but expected spot market only expect 0.35% appreciation, it means sterling is more expensive using forward rate than the expected spot. If you sell it today locking in a rate that implies 0.75% premium, and the actual premium in 1y ends up being only 0.35% you made money on your short.
If forward (1y) price is 100 and you expect something to cost 50 in one year, sell it in the forward market today and buy it back in in the spot market in 1 year and make 50.