in a foreign exchange market characterized by interest rate parity, if the domestic country has a lower risk-free-rate than the foreign country, the currency of the domestic country is most likely to be trading at a forward: a) discount and to appreciate b) discount and to depreciate c) premium and to appreciate d) premium and to depreciate ------------------------------------------------------ forward/spot=(1+rd)/(1+rf) if rd is lower than rf then the right hand side of the equation is small. assuming that the spot rate is constant, the forward rate should trade at a discount. can someone clarify?

It ask about the currency, not froward rate. Should be d. smaller rd leads to lower forward rate, means future depreciation for domestic currency.

steve 111, sorry forgot the type “at a forward”…

the forward is smaller on a direct quote basis (DC/FC) eg… S=2$/pound, F=1$/pound so the $ appreciates and is strong so it will trade at a premium

Assume that FX = Forward exchange - spot if FX<0, foreign currency is at a discount expressed in domestic currency units. In this case, you defined “domestic” as the one with lower real interest rate, therefore, the foreign currency is at discount, and domestic currency is at premium. C?

I would assume that given a lower domestic risk-free rate (i.e. treasuries) the demand for the domestic currency will fall which will result in a depreciation of the domestic currency. As a result, the forward exchange rate should increase, if using direct method(takes more $ to equal foreign currency).

C? Interest rate parity implies that the doemstic currency is at a premium. Lower Risk Free rate ==> currency will appreciate.

This is very interesting question. Make me think what forward rate really means. Domestic forward is definitely trading at premium. But think about in this way. Assume everything stays same. If forward premium causes it to appreciate, then because interest parity, it will continue to appreciate forever into the future. It does not make sense. I think in this static case, exchange rate will actually stay constant because everything should have entered into a new equilibrium. But I think they really mean to ask if interest rate become lowered what will happen to currency. In this dynamic case, it should depreciate. I think this question probably mixed up concept. Just a thought.

forward/spot=(1+rd)/(1+rf) rd forward/spot < 1 => forward

It has to be C. With D/F, F

Therefore, using my caveat I was wrong. Looking in the books, it says: “A FOREIGN currency is at a forward discount if the forward rate expressed in DC is < spot rate.” So the domestic currency must be at a premium if the forward < spot. so C). Perhaps this explains why I keep getting rubbish marks in SS6! Cheers guys this one helped!

I personally find this topic very confusing and usually get these questions wrong. Here is my understanding. Does this sound right? Or am I mixing concepts up? As per the CFAI text books a high Risk Free rate is associated with depreciation , which I assume is because the RFR includes an inflation premium. However a high real interest rate is associated with appreciation since the demand for the currency increases. A forward premium or discount does not necessarily mean that the currency will appreciate - It is just the forward rate that eliminates risk free arbitrage

just to let you know, this is a cfai sample exam question and the correct answer is c

Soudns to me that we can automatically rule out A and D. Since it it trading at forward premium, it will appreciate for sure in future. Sounds reasonable?

But the thing is : F/S = (1+rd)/ (1+ rf), if S decreases i.e DC appreciates, then F will decreases to make parity to hold, so it will continue to appreciate forever as long as interest rates stay the same. Also clearly, if a country lowers its interest rate, its currency will depreciate. Now because of interest parity, it will appreicate forever. It just does not make sense. I think I have spent too much time on this. Just remember the CFAI answer and moving on. Deal with this later. I think U.S. should drop interest to zero, so U.S. dollar will appreciate forever due to interest parity.

i’m doing on the subway train but my choice is B. if rD < rF, Fwd must be < Spot in order for the parity formula to balance. this is from math point of view. now if Fwd < Spot, then it must be expected to depreciate. is B the correct answer?

Sleepy, here is Barthezz’s post. Re: Int. Rate Parity Posted by: barthezz (IP Logged) [hide posts from this user] Date: November 19, 2007 06:16PM just to let you know, this is a cfai sample exam question and the correct answer is c

disptra Wrote: ------------------------------------------------------- > But the thing is : > F/S = (1+rd)/ (1+ rf), if S decreases i.e DC > appreciates, then F will decreases to make parity > to hold, so it will continue to appreciate forever > as long as interest rates stay the same. > > Also clearly, if a country lowers its interest > rate, its currency will depreciate. Now because of > interest parity, it will appreicate forever. It > just does not make sense. > > I think I have spent too much time on this. Just > remember the CFAI answer and moving on. Deal with > this later. > > I think U.S. should drop interest to zero, so U.S. > dollar will appreciate forever due to interest > parity. First off, the US dollar appreciating forever is not necessarily a good thing. Second, there’s arbitrage and there’s economics. In the forwards markets, arbitrage wins every time. So if the US interest rates dropped to 0 (it’s something like the repo rate that needs to drop to 0, btw) and the pound was yielding 6%, the pound would start trading at a 6% annual discount in the forward market. If not, there is an arbitrage to make it so. So now your best guess for the spot rate a year from now is that the dollar will appreciate by 6% because while forward rates are not great predictors of future spot rates, there is not any particular evidence that they are biased. If US interest rates dropped to 0 because there was no demand for US dollars, then the dollar probably wouldn’t appreciate by 6%. On the other hand interest rates dropping is supposed to take care of the demand part by itself so as the price drops the economy would pick up and demand would start again. But of course, sometimes it takes years to correct and then you have something like the yen carry trade that worked for years.

This is an interesting question. If they said the interest rate has JUST changed (yesterday) then the answer would be B. If the interest rate situation has been the way it is for awhile, then the answer if C. If domestic rate just dropped below the foreign rate, then the currencies will adjust (supply and demand blaaah blaaah), the domestic will drop in value and will trade at a forward discount (B). If domestic rate has been lower, and is expected to continue being lower than the foreign rate, then for interest rate parity to hold, domestic currency has to appreciate and trade at a forward premium ©. Seeing how the real CFIA answer is C, the latter must be true. Comments?

> First off, the US dollar appreciating forever is > not necessarily a good thing. > > Second, there’s arbitrage and there’s economics. > In the forwards markets, arbitrage wins every > time. So if the US interest rates dropped to 0 > (it’s something like the repo rate that needs to > drop to 0, btw) and the pound was yielding 6%, the > pound would start trading at a 6% annual discount > in the forward market. If not, there is an > arbitrage to make it so. So now your best guess > for the spot rate a year from now is that the > dollar will appreciate by 6% because while forward > rates are not great predictors of future spot > rates, there is not any particular evidence that > they are biased. > > If US interest rates dropped to 0 because there > was no demand for US dollars, then the dollar > probably wouldn’t appreciate by 6%. On the other > hand interest rates dropping is supposed to take > care of the demand part by itself so as the price > drops the economy would pick up and demand would > start again. But of course, sometimes it takes > years to correct and then you have something like > the yen carry trade that worked for years. Thanks! Let me try to understand this. For example: In the beginning U.S. interest is 5 % and British interest rate is also 5%. Now U.S. drop interest rate to 1%, investor will sell U.S. dollar right away, so in short term. U.S. dollar will depreciate. But now interest rate parity will start to kick in. So in the long term, U.S. dollar should start to appreciate if both countries hold its interest rates. This question asked about effect after the initial interest rate drop. So the answer is to appreciate. Is this correct?