The two questions below, I thought if the forward rate is lower than what interest rate parity indicates, then you should buy the undervalued currency and sell the overvalued. Based on my interest rate parity calculation, the forward rate should be 1.82%. In this question, the 1 year USD/GBP = 1.70, which is lower that what interest rate parity indicates. The GBP would be considered overvalued relative to the USD, and we should borrow it as opposed to borrowing the USD (the overvalued currency). We should buy the undervalued currency. No? What am I missing? And the opposite should be true for the second question below. ---------------------------------- Bowman begins his task by gathering the following current market statistics: # 1 year U.S. Interest Rates = 8% # 1 year U.K. Interest Rates = 10% # 1 year /₤ forward rate = 1.70 # Current /₤ spot rate = 1.85 ---------------------- Bowman knows that if the forward rate is lower than what interest rate parity indicates, the appropriate strategy would be to borrow: A) pounds, convert to dollars at the forward rate, and lend the dollars. B) dollars, convert to pounds at the spot rate, and lend the pounds. C) pounds, convert to dollars at the spot rate, and lend the dollars. Your answer: B was incorrect. The correct answer was C) pounds, convert to dollars at the spot rate, and lend the dollars. If the forward rate is lower than what the interest rate parity indicates, the appropriate strategy would be: borrow pounds, convert to dollars at the spot rate, and lend dollars. (Study Session 4, LOS 18.h) -------------------------- Bowman also knows that if the forward rate is higher than what interest rate parity indicates, the appropriate strategy would be to borrow: A) dollars, convert to pounds at the forward rate, and lend the pounds. B) pounds, convert to dollars at the spot rate, and lend the dollars. C) dollars, convert to pounds at the spot rate, and lend the pounds. Your answer: B was incorrect. The correct answer was C) dollars, convert to pounds at the spot rate, and lend the pounds. If the forward rate is higher than what interest rate parity indicates, the appropriate strategy would be: borrow dollars, convert to pounds at the spot rate, and lend the pounds. (Study Session 4, LOS 18.h)
I just did the calculations For the first question, A is not the answer. I am sure about that because you cannot convert currency NOW at the forward rate. So the answer should be B or C. First I borrowed 1000, I will have to pay 1080 in one year. Converted it into Pounds to give me around 540 pounds (1000/1.85) Then I invested that and got 594 pounds in 1 year (540 x 1.10) I converted it back into $ to give me $1010. (594 x 1.70). But this is a loss. So I choose C. Note: I did the calculations for borrowing Pounds 1000 and saw that it gave me a profit. Now since I knew that the answer was C for the first question, I just chose the opposite for the second one.
Oh, so just do the calculation? I didn’t do the calculation, I just figured, if a currency is undervalued relative to the other, then buy the undervalued currency and sell the overvalued one. No?
Damil4real Wrote: ------------------------------------------------------- > Oh, so just do the calculation? I didn’t do the > calculation, I just figured, if a currency is > undervalued relative to the other, then buy the > undervalued currency and sell the overvalued one. > No? I do not use this concept with currency valuation since it is very tricky. I prefer to do it using the old calculator friendly method. Maybe someone else will be able to give you a answer which will help you to solve this quickly. Since we have so many formulas and rules to do things, remembering this just adds to the pile.
Just for my own understanding, is the tottal risk-free profit around 75GBP using the info given? 1.85 X (1.08/1.1) = 1.82 > 1.70 So you know you want to convert dollars to pounds later at a “cheaper” rate of 1.70 relative to the arbitrage free rate of 1.82. Borrow, say, 1000 GBP. Must repay 1100 in a year. Buy forward rate contract of /GBP 1.70 Convert 1000 GBP to at 1.85 = $1850 Lend the $1850 at 8% so will have $1998 in one year. After a year, convert the $1998 / 1.70 = 1175 GBP Repay loan : 1175-1100 = 75 GBP risk free profit. Please let me know if I’m incorrect about anything above.
Hope I’ve gotten it, I so hope…: Scenario 1: Spot: 1 GBP = 1.85 USD Fwd : 1 GBP = 1.70 USD E(Spot) 1 GBP = 1.82 GBP (1.85*1.08/1.10) [spot rate in dom ccy terms x (1 + dom rate)/(1 + foreign rate)] Thus, the British Pound is “UNDERVALUED in the Fwd market” hence you shall “buy/Long it in the Fwd market” [BUY THE CHEAP] you want to be in a position to SELL USD in the Fwd market [SELL THE OVERVALUED] Logically, it would imply to redeem a loan in GBP using proceeds in USD, hence borrow GBP NOW and convert to USD at SPOT rates… invest in USD Buy GBP on the settlement date using the invested USD and fulfill your obligation. Scenario 2: the Fwd rate is HIGHER than what IRP commands ie IRP states 1 GBP = 1.82 USD Fwd (assumed) 1 GBP = 1.84 USD Now, the USD IS UNDERVALUED in the fwd market, hence I’d BUY it in the fwd market. the GBP is OVERVALUED hence I’d SELL it in the fwd market. To sell GBP on that future date I’d need GBP proceeds, To have a purpose for the bought USD I’d need an obligation in USD to be fulfilled… That could only mean Borrow in USD now, convert to GBP spot, and Invest in GBP… till the date of settlement. ie option C ========================= This is very cumbersome I know, until someone else comes up with a better one, this is all I’ve got. Just trying to help. I just came up with the axiom: … BUY & BORROW the CHEAP … SELL & INVEST the OVERVALUED.
My way of looking at this is that we’re pricing Interest Rates . Is the UK Interest rate too cheap or is it too expensive? If it is too expensive, we borrow dollars so we have pounds and earn a higher rate on pounds , if it is too cheap we borrow pounds so that we come out ahead as parity catches up. In the first example , UK interest rates are cheap ( 1.7 * 1.1 < 1.85*1.08 ), so borrow pounds and lend dollars . Check out : http://azarmi.info/wp-content/uploads/2009/05/2-interest-rate-parity-irp.pdf
To be clear: IRP: F/S = (1+Rf)/(1+Rd) F/S=1.7/1.85 = 0.919 (1+Rf)/(1+Rd) = 0.98182 So Rf is too cheap , relative to Rd , take advantage by borrowing pounds now ( paying low rates ) and lending dollars now ( getting high rates )
Darius-I Wrote: ------------------------------------------------------- > Hope I’ve gotten it, I so hope…: > > Scenario 1: > > Spot: 1 GBP = 1.85 USD > Fwd : 1 GBP = 1.70 USD > > > E(Spot) 1 GBP = 1.82 GBP (1.85*1.08/1.10) > > > > > Thus, the British Pound is “UNDERVALUED in the Fwd > market” > > hence you shall “buy/Long it in the Fwd market” [> BUY THE CHEAP] > > you want to be in a position to SELL USD in the > Fwd market [SELL THE OVERVALUED] > > Logically, it would imply to redeem a loan in GBP > using proceeds in USD, > > hence borrow GBP NOW and convert to USD at SPOT > rates… invest in USD > > Buy GBP on the settlement date using the invested > USD and fulfill your obligation. > > > > > Scenario 2: the Fwd rate is HIGHER than what IRP > commands > > ie IRP states 1 GBP = 1.82 USD > > Fwd (assumed) 1 GBP = 1.84 USD > > > Now, the USD IS UNDERVALUED in the fwd market, > hence I’d BUY it in the fwd market. > > the GBP is OVERVALUED hence I’d SELL it in the fwd > market. > > To sell GBP on that future date I’d need GBP > proceeds, > To have a purpose for the bought USD I’d need an > obligation in USD to be fulfilled… > > That could only mean Borrow in USD now, convert to > GBP spot, and Invest in GBP… till the date of > settlement. > > ie option C > > > ========================= > This is very cumbersome I know, until someone else > comes up with a better one, this is all I’ve got. > Just trying to help. > > I just came up with the axiom: > > … BUY & BORROW the CHEAP > … SELL & INVEST the OVERVALUED. But isn’t GBP overvalued relative to the USD in the future in question 1? interest rate parity calculation, the forward rate should be 1.82%. In this question, the 1 year USD/GBP = 1.70. This means the USD should really be worth more, but it’s currently being priced to worth less. Buy the USD (cheap) and sell the GBP (overvalued). What am I missing here?
> But isn’t GBP overvalued relative to the USD in the future in question 1? NO, GBP is undervalued relative to USD in the forward market in question 1. I will try to explain, as per the reasoning given by you. ‘Calculated’ Forward rate is 1.82 and ‘Market’ Forward rate is 1.70. That is, in the market 1 GBP buys less USD (1.70 only) than what it should actually buy (1.82). What does this mean? It means GBP is undervalued in the Forward Market. Does it clarify? Also, I would recommend janakisri’s method. Crisp, does not take time and would produce 100% accurate result. Maybe go thru janakisri’s first post again. All he is saying is, since our calculated 1.82 is higher than 1.70, which means, either our numerator (which is US interest rate) is too high OR our denominator (UK interest rate) is too low. In either situation, you want to borrow money in GBP (which may have interest too low) and lend in USD (which may have interest too high).
Ah, there it is. I think I see the error of my observation/calculation. Thanks, dude.
Better to think of the domestic rate as a given . So we’re pricing the foreign rate ( Rf ) only . Helps reduce mental clutter. In parity problems to with rates , just focus on : Is Rf cheap or expensive ? Answer to the above question would be : F/S compared to ( 1+Rf)/(1+Rd) Left side F/S, given Right Side (1+Rf)/(1+Rd) . If left is higher , Rf is cheap-> Borrow foreign ( equivalent to Buying the Rf) If left is lower then Rf is expensive-> Borrow domestic ( equivalent to Selling the Rf)