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Greetings Tutor. I hope you are doing well.
Can you help me with the followingA company is based in the US. The domestic short-term US$ interest
rate is 3% per year.
The equivalent rate in Euros is 6% per year. The current exchange rate
is:
0.94 Euros = $1Calculate the forward rate predicted by interest rate parity in (a) 6
monthsCalculate the simple interest over 6 months:
US$ = 3% × 6/12 = 1.5%,
Euro = 6% × 6/12 = 3%
Forward rate = 0.94 × 1.03/1.015 = 0.954 Euros/$.I’m okay with everything. All I want to know is why are we taking simple interest?
Why aren’t we calculating the effective half yearly rate. The effective half-yearly rates are:For a 3% annual rate: 1.489%
For a 6% annual rate: 2.956%In the context of calculating forward rates using interest rate parity, simple interest is often used for ease of calculation and clarity in understanding the relationship between the interest rates of the two currencies over a short period, such as 6 months.
So….the use of simple interest allows for straightforward proportional calculations based on the annual rates divided by the number of periods.The effective half-yearly rates you mentioned (1.489% for 3% and 2.956% for 6%) could be used for more precise calculations, but they are not always necessary for basic forward rate calculations under interest rate parity. Keep things simple.
Thankyou Tutor.
I have noticed that in certain part of syllabus (such as Working Capital Management) effective intrest rate are computed while in risk management they have used Simple Intrest.So is there any specific guidelines as to which one to use under which part of our syllabus
In Working Capital Management, effective interest rates are often computed to provide a more accurate representation of the cost of financing. This approach allows for a detailed analysis of cash flows and the overall financial health of a business.
Whilst in risk management, particularly regarding interest rate risk, simple interest is typically used because it simplifies calculations and helps in understanding the basic concepts without the complexity of compounding.
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