Question. If Euro interest rates are 5% and USD is 3%. Why would the USD forward trade at a premium to EUR? Is that because the implied inflation for EUR is higher and therefore it is expected to depreciate?
Consider SR = 1.5 EURO/USD FR = 1.5*1.05/1.03 = 1.5291 Hence USD will Trade at a Forward Premium IR(US) > IR(EURO), investors will want to invest in US to get that better rate, demand to buy USD will be high and the supply of EURO in Fx will be high. Hence USD is expected to appreciate.
OK that’s why I was confused because the first part of your answer seemingly conflicts with the second part. I follow the math in the first part and I follow the logic in the second part however IR(US) < IR(EUR) in first part and IR(US) > IR(EUR) in second part
Schweser says the idea of IRP is that changes in exchange rates will just offset the differences in interest rates. The currency with the higher nominal interest rate will depreciate. When/If IRP holds, an investor makes the same return holding either currency. In your example above, the EUR is paying a higher nominal rate so the EUR will depreciate (So that 3% USD return = 5% EUR return; Eur must fall relative to USD). I think you stated correctly that the USD trades at a premium relative to EUR due to IRP holding and EUR depreciating relative to the USD.
correct man - I got number of QBank q’s wrong because of the same messup. So if they give number, I do it the number way (part-1), but if they ask in terms of increase/decrease I do part-2 