Domestic country has lower risk free rate than foreign country, the currency of domestic country is most likely to be trading at a forward: A discount and appreciate B discount and depreciate C premium and appreciate D premium and depreciate Ans is C. I can understand it is to appreciate. Say Spot rate is now 2 $/Pound, because Rd
“a *foreign* currency is trading at a premium if F>S” So the domestic currency is at a premium if F
oops, thanks for pointing this out
i had this exact same question…although, shouldnt their curreny DEPRECIATE??? the domestic country has a LOWER interest rate, therefore its currency should DEPRECIATE… ??? their will be money flows towards the country with the higher rate, thus, demand for the local currency will drop, depreciating it… i really dont see how it can appreciate pls explain?
Bluey, I just read the schweser section regarding this and I agree with you that the domestic should “depreciate”. for e.g. the real interest rate will decrease due to an expansionary monetary policy which would increase imports and demand for foreign goods making the domestic currency drop. I agree that domestic should trade at a premium though as F
thanks niraj, and you’re correct… the domestic does trade at a premium so, can the cfai be wrong, or is there another logical answer to why they think the domestic appreciates?
i wish someone would answer so we can nail this question come saturday…
I missed this question too… but it says it here: Say Spot rate is now 2 $/Pound, because Rd
Bluey do you think they are asking what the DC will do in the future (appreciate) and not what it is at right now (depreciatED) ?
Here’s how I would approach this problem. I think it highlights a few potential pitfalls. The domestic currency has a lower risk free interest rate than the foreign currency. We are assuming there is no arbitrage opportunity. Thus, those who invest in the lower risk-free interest rate in the domestic country need to benefit from currency appreciation to keep up with higher interest rates elsewhere. The domestic currency will appreciate. So the answer is either A or C. Now for the premium/discount analysis. Here it is vital to keep the exchange rates straight in terms of DC/FC. The rule is that if the forward rate, quoted in DC/FC, is greater than the spot rate, quoted in DC/FC, then the foreign currency is trading at a forward premium. Here, let’s call the domestic country the United States and the foreign country Canada. Let’s assume the current spot rate is $2 USD/CDN and the forward rate is $1 USD/CDN. That’s consistent with our analysis above that the United States dollar will appreciate, since it takes two United States dollars to buy a Canadian dollar today but will only take one US dollar to do so tomorrow. Doing the math, $1USD/CDN (Forward) - $2USD/CDN (Spot) gives us a negative number, so we know the foreign currency (Canadian dollar) is trading at a forward discount. That means the domestic currency (US dollar) is trading at a forward premium. So the answer is C: the domestic currency is trading at a forward premium and will appreciate. I think there are two potential sources of confusion here, mechanical and conceptual. Mechanically, it is key to quote exchange rates in DC/FC and to realize that the equation Forward – Spot speaks to whether the foreign currency, not the domestic currency, is trading at a forward premium or discount and will accordingly appreciate or depreciate. It is important to remember that the interest rate parity equation is Forward (DC/FC)/Spot (DC/FC) = 1 + Rd / 1 + Rf. Mixing up the DC/FC sequence and/or the positioning of the domestic and foreign interest rates can rapidly lead one astray. A second source of confusion is that what we are saying here that since the domestic interest rate is lower, the domestic currency will appreciate. But in economics don’t we say that a lower interest rate will cause a currency to depreciate – not appreciate? There may be some conflict here, but not necessarily. Let’s assume the Canadian risk-free rate increases so that it is five times as high as the US rate. Our economics analysis says the Canadian dollar will appreciate immediately as investors buy up the great Canadian risk-free securities. In other words, the USD/CDN spot rate will increase (more USD to buy 1 CDN). But our foreign exchange analysis says that the USD/CDN forward exchange rate cannot change by the same amount, because if it did, people could borrow at the relatively inexpensive US risk-free rate, invest all the proceeds in Canada, and then convert their returns back to US dollars at the same forward rate. So I think the result is that the USD/CDN spot rate increases immediately but the USD/CDN forward rate stays lower in light of arbitrage.
<> This is great. I think this is really the heart of the matter for myself and many others who get hung up on IRP. Clearly, in their discussion of balance of payments, CFAI clearly states that a relatively higher interest rate results in higher demand for the currency, leading to currency appreciation (Reading 30, pg. 502). However, IRP clearly states that the country with the higher interest rate will actually have a forward rate that is at a discount. This seems to be a necessity to prevent arbitrage, as you talked about. So like you said, distinction is between forward rates and spot rates. Excellent post!
so what would be the correct way to go in the exam? i so don’t want to lose points because until now i knew that lower rate = depreciating currency, and now this question says to do the opposite. i guess ill go with what ive learnt if no one advises otherwise.
By DEFINITION a currency trading at a discount (meaning the forward
ahhh thanks longoncfa… thats explained it really well… and thanks chebychev, nice detailed post… but that question is still a fhkn mind-bender to me, and i hope it doesnt come up