Trading the forward rate bias

I have difficulties in understanding how trading the forward rate bias actually works, more specifically EOC 18, Reading 19 (currency mng): we have a carry trade on INR/USD, and it is mentioned that a higher forward premium for INR/USD would be most favorable for this strategy (answer B ). This is not very intuitive for me, can someone explain it in simple words?

Thanks!

A higher forward premium means that the interest rate differential is greater, so there’s more scope for profit.

I think I’ve over analyzed the EOC question or something, because now your comment seems so obvious to me, and my question seems quite stupid :slight_smile: Many thanks !

You’re welcome.

S2000magician, can you kindly explain the bolded portion of your comment - FX is something that makes no intuitive sense to me. Wouldnt a forward discount also imply an interest rate differential that is greater? I saw a helpful post by CPK somewhere that explains this concept through the following:

F/S-1 –> if positive - denominator is at premium (numerator at discount)

F/S - 1 –> if negative - denominator at discount (numerator at premium)

I am still scratching my head here.

To be honest, this question is kind of an *******, and here’s why:

it is true that the higher the forward premium, the more profitable a carry trade is likely to be. The way the question is worded, however, does not make it clear what the process of events is. Here is the question:

[Question removed by admin]

So here’s the thing - if the guy executes the trade, and THEN the “event” happens, then B would actually be a very bad thing for this guy - he’s gone short on the USD, and a higher forward premium on it means it is appreciating. this is the same thing as if you go short on a stock, and then it goes up in value - it screws you. In option A, (a narrower interest rate differential), this means that either the Indian interest rate is dropping, or the American one is rising, or some combination of the two - either way, PPP will make the USD depreciate against the INR, and conversely, the INR will appreciate. if you’ve executed this trade, you are long the INR, and short the USD - you want the INR to appreciate, and the USD to depreciate, but again, you only want that if you’ve ALREADY EXECUTED THE TRADE. I’ll elaborate: Suppose at the start of the carry trade, the indian rate is 10%, and the US rate is 1%, furthermore, 1 INR = $.10 (or 10 INR = 1). Using PPP, the forward rate on the USD is 10.89 RU [(10x(1.1/1.01)]. Then, assuming the spot prices stay the same, but then the US interest rate goes up to 5% in the USA, then the forward rate on the USD changes to 10.48 RU per - or as I said earlier, a depreciated US dollar (since I now need fewer Rupees to buy a $). So for my carry trade, I get my 10% INR return, which means my 10 rupees have turned into 11 after a year of being invested, and thankfully the USD is available to me at a cheaper price due to that relatively increased US interest rate, so I get an even higher return than my carry trade would have otherwise given me. In other words, if you assume the guy actually does the trade, and then the event happens, the answer is actually A (which is effectively a cheaper US dollar spot price relative to the INR). However, That’s not what’s going in the question. The question is saying that the guy has not done the trade, he’s just looking at it. THEN this event happens. In that case, it is more appealing to have a wider forward premium to work with at the START of the trade, because there is less chance that the spot price of the borrowed currency will appreciate up to a level that erases your returns from investing at the higher interest rate in the discount currency. IF YOU ASSUME THE GUY IS JUST LOOKING AT THE TRADE AND WAITING TO EXECUTE IT, THEN THE ANSWER IS B, WHICH IS WHAT THE CFA ACTUALLY PUT AS THE ANSWER, ie “a more profitable trading opportunity”. It’s sort of like asking the question “a guy is considering buying an $8 stock that he knows for a fact he’ll be able to sell for at least $10 in one month’s time. which event would give him the most profit?” A) stock increases to 13 B) stock decreases to 6 C) something stupid Assuming the guy hasn’t bought yet, the answer is B, but if he did (at $8), then the answer is A. Same **** as this question. The question should have specified that the position has not yet been taken. I lost a lot of time reflecting on this ****.

Can we go out and have a cup of coffee?

Magicskyfairy very good point…i was scraching my head, how can you make profit if you short USD and USD is appreciating…I think CFA questions are now not only testing whether you master the concepts, but also if you can read English…

let me guess, the author wrote the question in 2011 and the trade would have completely failed.

anyway, its a question on present/future tenses in the question. I.e. testing your english comprehension.

“I am considering borrowing in USD” and “market developments would be most favorable”

so he is not yet invested.

A) this would be good, if the trade was already in place. but it is not yet done.

B) this means INR bond yields would be higher. So all else being equal this is the best. the reason for the move is not discussed.

C) the investor will leverage the trade, so volatility is bad and would create margin calls.

Anyway from the chart you can see it was only ever going to lose money. So a bad idea and clearly he needs to look at the IPS

I agree with your opinions on this question. Please allow me to repeat your logic in a more organized way.

Actually, for this question, I tend to think from the mathematic view. The prerequisite of the carry trade is:

image

As given by the question, the currency pair is INR/USD, so USD is foreign currency, INR is domestic currency. The profit of this carry trade is calculated as:

image

image is the borrowing cost
image is the gross profit. In detail, this term means “borrow 1 USD → convert to INR → earn the INR interest → convert back to USD at forward price”

Then comes back to examine the choice of this question solely based on the math formula:

  • A is wrong, a narrower spread decreases the gross profit
  • B is also wrong, higher forward premium on USD increases F, thus decreases gross profit
  • C, the volatility is irrelevant to this question, forget it

Now, here is why @magicskyfairy 's explanation values:

  • If the guy already executed the trade, A is correct. Let’s assume the guy makes a term deposit, so he already locks in the image profit and image borrowing cost. In this case, a narrowing down spread drives USD forward price down, which increases the gross profit.
  • If the guy has not yet executed the trade, B is correct. Higher premium on USD generally indicates larger spread between India and US interest rate. As stated in the description, the guy is not going to use currency hedge, so he cannot lock in the USD forward price. Then this guy must be a foreseer, as he really knows USD won’t appreciate more in the future.

This question is really bad. Actually I don’t think CFAI books demonstrate carry trade on currency well. Instead, they explain currency carry trade from a very naive way, always under unrealistic assumptions.