INTEREST RATE PARITY: Schweser Level 3, Volume 2 Exam 2, PM: #57

CFA Level III
#1

Hi guys i could really use some help with this one.

The correct answer is A, “Sell EUR forward, buy USD? No. Sell EUR forward buy JPY yes.”

The 1st part, selling EUR, buy USD, i just dont get. So if someone could just walk me through it, i would really appreciate it.

The second part is as follows: S = 0.00667 Yen / EUR, and F = 0.00767 Yen/EUR, but we’re to assume nominal rates in Yen and EUR are the same. My intuition tells me to buy Yen when it is cheap (now at 0.00667) and sell it when it is expensive (in the future, or forwards, at 0.00767).

Here is my logic : nominal rates are the same in all 3 countries. let’s assume rates = 10%. Then i can borrow 1000 EUR now at 10% (and owe 1100 EUR in the future). BUY yen and convert to yen 1000 / 0.00667 = 149,925 Yen. Get 10%, 149,925 * 1.10 = 164,918 yen. Then because I’ve SOLD yen forward (agreeing to deliver yen for eur) convert it back to EUR 164,918 * 0.00767 = 1265 EUR. Pay back 1100 EUR and earn 165 EUR with no risk.

Where am i wrong here?

#2

*bump* any input would be appreciated

#3

hey ajc3388.

in the question it says “assuming all real interest rates and inflation rates are equal” across the three countries. Therefore, if they are all equal, then spot rates should equal forward rates at the beginning.

Further

EUR/USD went from 0.75 to 0.70, therefore USD Depreciated, EUR appreciated. Had we hedged, we would have locked in a higher rate for USD, and hence a lower rate for EUR of 0.75, so compared to unhedged and letting the EUR appreciate to 0.70, hedging underperforms

Secondly (and oppositely)

EUR/YEN went from 0.00667 to 0.00767, so YEN appreciated, EUR depreciated. It would have been smart to have SOLD EUR forward at 0.00667 and in turn bought YEN at 0.00667 and upon maturity realized the price appreciation of YEN to 0.00767