Reading #18 - Schweser question 4 page 78

Going through the questions on FX and find the answers from Q4 rather strange. The answer stated B that IR must be higher in the US than in New Zealand. This does not make sense given the fact that Spot rate = 1.4286 NZD/USD and Forward rate = 1.3889. Any suggestions on this.

So NZD is expected to appreciate, so by covered interest rate parity, interest rates must be higher in US. It’s right.

You should go back over pages 69-70 of Schweser, especially the example on page 70. The question is asking which way the interest rate differential runs when forwards are at a discount to spot. The formula is forward = spot x (1+r of NZD)/(1+r of USD). Since forwards are at a discount, you know that the ratio of 1+ r of NZD over 1+r of USD is less than one, therefore USD interest must > NZD rates. Also in answering the question you can elminate answers C and D since they both say the same things, i.e., the NZD depreciation = USD appreciation, so then the answer can only be A or B, and that’s when you apply above interest rate parity formula.

Thanks guys. I was confused between the way they define risk free rate. I gather from reading the book is that if it is Risk free rate = Nominal rate That means an increase in rate will mean a decline in the underlying ccy. If Real Risk Free Rate increases, which will translate to increase in the underlying ccy

Forward rates are governed by covered interest rate parity (it’s an arbitrage enforced relationship). Expectations and inflation are irrelevant to forward rates.