Question on spot, forward and interest rates.

CFA Level I
#1

Hi, could anyone be kind enough to explain to me the rationale of this question pls?

The spot rate on NZD is NZD/USD 1.4286. The forward rate is NZD/USD 1.3889. This difference means:

A. interest rates are higher in USA than in NZ.

B. interest rates are lower in USA than in NZ.

C. it takes more NZD to buy one USD in the forward market than in the spot market.

The answer is B. However, i don’t understand why this is so. If the NZD is expected to strengthen in the future, doesn’t this mean that interest rates are higher in NZ than in USA?

Thanks in advance for any clarification provided!

#2

First, it appears that answers A and B are identical; please correct one of them.

This is a simple application of interest rate parity (IRP): if it takes fewer NZD to buy one USD in the future, then NZD interest rates are lower than USD interest rates: NZD are growing at a slower rate than USD.

I wrote an article on IRP that may be of some help here: http://financialexamhelp123.com/covered-interest-rate-parity-irp-pricing-currency-forwards/.

#3

Hi S2000magician, I’ve edited my post. Thanks for your prompt response!

I read your article and I understand it now. It is due to the interest rate parity formula - the numerator must be growing slower compared to the denominator (USD).

I don’t seem to understand the intuition behind it though. I keep thinking that if NZD is expected to appreciate, that means there’s expected to be demand for the currency and high interest rates are a factor, hence the demand.

#4

There are multiple forces that affect currency exchange rates; interest rate parity looks only at comparative (risk-free) interest rates, not at other factors (e.g., world-wide demand).

The intiution is contained in the no-arbitrage condition: if you have USD and invest them risk-free, you should earn the USD risk-free interest rate. You can try to be sneaky by converting your USD to NZD, earning the NZD risk-free rate, and then converting them back to USD, but all that does is complicate your life for no gain: you still earn the USD risk-free rate.

#5

Understood and thanks for your time!

PS I’m a great fan of the S2000 too but unfortunately from where I come from, it’s too expensive to buy/maintain one.

#6

My pleasure. Glad it helped.

Mine’s an '01 with 212,000 miles. Time for a new engine, alas.

#7

Please correct your answer in the first post. Don’t want people to get misled to believe that B is the correct answer and get confused (as I did). The correct answer is A.