If IRP holds, the ACU should depreciate against the GBP by approximately 1.25% over the next six months.”
Now, on the Schweser’s quick sheet (SS9: asset allocation (2)), it states that “increases in currency values are associated with currencies with higher real or nominal interest rates.” Intuitively this makes more sense to me, and it looks like the two statements are contradicting each other. I thought higher rate = increase in currency value, and the first example (question 7, C) seems to contradict this point by saying ACU (which has a higher interest rate) should depreciate.
Am I missing something? Or is it just IRP assuming there’s no arbitrage so it’s “expecting” the currency with the high interest rate to depreciate? I didn’t do well in this part in level 2… if anyone could clarify the concept, it would be helpful. Thank you.
Determine whether Gupta should hedge the currency risk in Alphastan government bonds over the next six months, assuming the economist’s currency forecast is correct. Justify your response. 3 minutes
Gupta should not use a forward hedge to lock in a currency loss of 1.25%. The economist forecast that ACU will depreciate by 1.0%.
Justification: According to IRP the expected depreciation of ACU over the next six months is
Just aside for the same 2014 CFA exam itself, Question 9 B ,should we always assume fixed rate duration to be 75% of the maturity…What’s the rule for the fixed rate duration if no abolute number given?
i believe the general rule is 75% for fixed and 50% of the payment period for float. I did see a question that gave the duration of the fixed side of a swap and it wasnt 75%, so that threw me off a bit. #44 of Schweser exam 2 PM
If IRP holds, then you shouldn’t be able to make more money by depositing in ACU (whichever crazy Alphastan country that is). So the benefit of earning 5% in ACU should be cancelled by a depn in ACU to the tune of the differential given because you’ll sell more ACU at the end of the day and get lesser GBP. But as S2000magician said, only IRP doesn’t govern FX markets. You can’t say that FX markets is only driven by interest rates and its differentials and nothing else. For ex: A higher interest rate in ACU would bring greater flows into ACU causing an appreciation in its currency which could then cause lesser inflation and decreased exports ultimately causing interest rates to fall to enhance inflation and depreciate the currency thereby increasing exports. Hope this helps!
CIRP determines the forward exchange rate Ft (the price at time 0 of a forward contract maturing at time t) based on the principle of no arbitrage. It states that if a currency has a higher interest rate, it will trade at a forward discount ~i.e. forward exchange rate being lower than the spot exchange rate, thereby producing an offsetting compensation.
In contrast, the Schweser quicksheet quote “increases in currency values are associated with currencies with higher real or nominal interest rates” is referring to the spot exchange rate at a future date, St, which is not known at time zero.
This is different from Ft, which is known at time zero.
CIRP only determines Ft, not St. In fact St usually moves in the opposite direction than that implied by interest rate parity: a currency with higher interest rate and trading at a discount in the forward market will usually appreciate in value, due to the inflow of hot money seeking higher yield.
This phenomenon (currency with higher nominal / real interest rate increase in value) is called a violation of Uncovered Interest Rate Parity (UIRP) and is the basis for the carry trade (borrowing in lower interest rate currency and using the proceeds to invest in higher interest rate currency).
A very difficult concept which I only grasped in Level 3 and I dare say we are in good company, so don’t feel bad.