Monetary Tightening & Forward Points

CFA Level III Economics
#1

Björk then examines the fund’s EUR-denominated exposures. Due to recent monetary tightening by the Riksbank (the Swedish central bank) forward points for the SEK/EUR rate have swung to a premium. The fund’s EUR-denominated exposures are hedged with forward contracts.

Anything FX gets my mind in a pretzel. So if Sweden is tightening (raising Swedish rates), then SEK should appreciate vs the EUR on capital inflows. In other words EUR should depreciate against the SEK.

Therefore I’d expect forward points (quoted in terms of EUR base currency) to swing to a discount.

What do I have wrong here? Appreciate any help.

#2

Forward points are based on interest rate parity (to prevent arbitrage), not on expected future exchange rates.

#3

why would Swedish Monetary Tightening make SEK/EUR swing to a Forward premium?

#4

Interest rate parity.

Suppose that SEK/EUR is 11.6621, the 1-year SEK risk-free rate is 2%, and the 1-year EUR risk-free rate is 4%. The 1-year forward rate is SEK/EUR 11.4378, so the forward points are −2,243.

Now, the SEK 1-year risk-free rate jumps to 6%. The 1-year forward rate is SEK/EUR 11.8864, so the forward points are +2,243.

#5

got it thank you

#6

My pleasure.