I was doing some econ questions and came across this one in schweser’s q-bank: Given: 1 year U.S. Interest Rates = 8% 1 year U.K. Interest Rates = 10% 1 year /Euro; forward rate = 1.70 Current /Euro; spot rate = 1.85 Based on the information above, Bowman would like to calculate the forward rate implied by interest rate parity. The answer is: A) 1.82 /Euro;. B) 1.88 /Euro;. C) 1.67 /Euro;. Your answer: B was incorrect. The correct answer was A) 1.82 /Euro;. Given the above relationship, interest rate parity does not hold. (If interest parity held, 1.70 = 1.85 × (1.08 / 1.10), but 1.85 × (1.08 / 1.10) = 1.82). ************************************************************************ Does Schweser have this one mixed up? According to CFAI: F = (S(1 + rb)) / (1 + ra) = ((1.85(1 + .1)) / (1 + .08) = 1.88426 $/Euro; Am I overlooking something simple? Thanks, TheChad
F/So = 1+Rfc/1+Rdc but in the left side, S & F are quoted DC:FC so it’s 1.7 = 1.08/1.1 x 1.85, or 1.7 = 1.816364 you just flipped the 1.1/1.08 instead of using the 1.08/1.1… and of course they had that answer there.
Thanks! I am still not sure why it is 1.08 / 1.1 x 1.85. Like you said: F/So = 1+Rfc/1+Rdc The Euro is listed as the foreign currency and Rfc = 10% The $ is lised as the domestic currency and Rdc = 8% That being said, solving for F we get: F = S0 x (1+Rfc/1+Rdc) = 1.85 x (1.1/1.08) = 1.88426 I apologize for my ignorance, but why would these values be flipped in this example? Thanks, TheChad
deleted my post…
i have on a notecard that something like: 1 year /Euro; forward rate = 1.70 is quoted DC:FC, which is the same as saying FC/DC. meaning here the would be the FC and the E would be domestic. could schweser have it wrong the whole way? i wouldn’t be surprised, but if their logic is right then i’d agree with that q-bank answer. anyone else? i am tempted to open up the CFAI econ text now to clarify this.
You are right…I knew is was something small that I overlooked. Thanks for the clarification Schweser likes to use the b/a format a lot. I will be sure to keep my eyes peeled for this in the future. Thanks again! TheChad
settled- qbank is right. CFAI text pg 585 has the formula, but then states “where S and F are quoted as DC:FC (the amount of foreign currency that one unit of domestic currency can buy)” so /E = FC/DC... hence you do the /E on the right side also. agree?
chad- this is actually the first year they’re using the DC:FC notation thing… this wasn’t there last year. tiny, small, almost silly thing but easily could trip folks up come exam day on little questions like this one, flipping numerators and denominators. i’m normally pretty good on econ, but it’s definitely a section to come back to in q-bank here and there just to refresh all of those parity equations. they’re not hard but it’s easy to trip up on them. i hope all 6 q’s are on tri-arb. they won’t be- i’ll get more BOP which i really still haven’t put into my memory yet.
The best way to keep this in order… 1) Notice that the Euro needs to depreciate because the i-rate is higher 2) Notice that this leads to less $/Euro => lower forward rate So now you know that the correct orientation is 1.08/1.1 X 1.85 resulting in a lower forward of 1.82. You’ll never mix it up again! They’ll kill you on the test if you can’t spin these around.
Thanks guys. Ruins…that is a good way to remember it as well. Right before that question I was killing myself trying to wrap my head around CFAI question #1 at the end of reading 19…for some reason it just didnt make intuitive sense to me…now that I feel like I have a decent grasp on it, this will help me on the test. Thanks again TheChad