Casasophia Jun11

They do not form a direct part of any of the hedging strategies available. The only relevance is in calculating the forward rates.

John Due to the question request the 20M received shall be invested in 2 months at T bill interest but in the answer, we have nothing to do with the requirement, is it surplus details of question

For part (a) it is irrelevant because the question only asks about hedging in relation to the receipt in 4 months time (not what will happen afterwards). It is relevant in part (b) but only there for estimating the forward rates (using interest rate parity).

In part b to calculate the expected forward rate Interest rate parity is used, and then Purchasing power parity is used for calculating the expected spot rate use for investment amount. My question is how we know which parity to used? -I mean can i used purchasing power parity for both or Interest rate parity for both? -If Not then why?

It is always interest rates that determine forward rates (the lectures on forward rates and money market hedging explain why). For forecasting future spot rates, in a perfect world both inflation rates and interest rates would result in the same answer. However in reality they do not, and inflation rates are regarded as a better predictor of future spot rates. In the exam you should always use inflation rates to predict future spot rates.

It might seems silly but can you describe and briefly explain what is the difference between Forward rate. Expected spot rate. For me both are same, and both Interest rate parity and purchasing parity are used to predict the future exchange rate, i dont find any difference between them !. I would be be very thankful to you if you clarify this.

You really must watch the free lectures - you cannot expect me to type them all out here - because it is all explained in great detail in the lectures. The spot rate on any day is the rate at which money is converted on that date. The spot rate changes from day to day for all sort of reasons. The only way you can be expected to forecast a future spot rate in the exam is to use the inflation rates. A forward rate is completely different. It is a rate quoted by the bank to apply on a future fixed date. If you accept the forward rate then you have to convert money at that rate on the future date (whatever the spot rate on that date happens to be). Using a forward rate is one way of hedging against the risk of the spot rate changing in the future - again, you convert at the fixed rate whatever happens to the spot rate. Please watch the free lectures (and if needed then the relevant F9 lectures as well, because this bit of risk management is revision of F9).

Thank you very much, I know i ask some questions which souldnt be asking at this level, but you answered them. Thanks again. :)

No problem :-)