it is said that: “IRP says that the forward premium or discount should be equal to the interest rate differential. Assuming IRP holds, the FCRP can also be calculated as the percentage difference in the expected exchange rate and the forward rate: FCRP = {[E(S1) - F] / S0}” here, the interest rate differential, what interest rate differetial? domenstic interest rate - foreign interest rate? dose it have anything to do with the term structure of interest rate? thanks. usually E(S1) is the same as exchange rate in future/forward, how could it differ? Thanks.
At the risk of embarrasing myself, I think you are missing a part of the equation. It is FCRP = (ES1-F/So) - (RDC-RFC)
Isn’t it [E(S1) - So]/So - (rDC - rFC) and for forwards its (F-So)/So - (rDC - rFC)?
the idea is that when forward price is below expected future price, there is a risk discount. FCRP = (E(S1)-F)/S0 is the correct formula then since F = S0*(1+rDC)/(1+rFC) , F/S0 = appr = rDC-rFC -> F can be replaced in the previous formula
hw0799 Wrote: ------------------------------------------------------- > it is said that: > “IRP says that the forward premium or discount > should be equal to the interest rate differential. > Assuming IRP holds, the FCRP can also be > calculated as the percentage difference in the > expected exchange rate and the forward rate: > > FCRP = { E(S1) - F]/ S0}” > > here, the interest rate differential, what > interest rate differetial? domenstic interest rate > - foreign interest rate? > dose it have anything to do with the term > structure of interest rate? thanks. > > usually E(S1) is the same as exchange rate in > future/forward, how could it differ? Thanks. The interest rate differential here depends on how you quote the FX. If your quote is DC/FC, then the differential is rDC - rFC. Otherwise, rFC - rDC. It surely has something to do with the domestic and foreign term structure. E(S1) could theoretically deviate from F. It’s the efficient estimator of future exchange rate. Let’s say F = 6.0 RMB/USD 1 year from now. You could totally hedge out your FX risk by entering into the forward contract. But you could gain exposure to this risk if you have a different expectation of how F would be.