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Hi John,
Why in part b) of the question we use PPP but in part c) we use IRP? Why for example not to use PPP in both cases as PPP is better predictor of future spot rate. Is there a rule which method to use if information for both methods is avalible in the question?
Thank You!)
I got it – question says that the inflation rate for the oversea country is applicaple for 6 month only so in part c) IRP would be more accurate estimation.
Not really.
PPP is better for forecasting future spot rates.
However, forward rates (in part (c)) are always calculated using IRP. (If you watch the free lectures on money market hedging and using forward rates, I explain why this is the case.)
I watched lections but still do not get:
1) Why PPP is better estimation for the future spot rate as compared to IRP estimation for the forward rate?
2) Do we use in that question in part c) forward rates as proxy for future spot rates?
3) Which rates should be used in NPV calculation:
– Future spot rates calculated using PPP or
– Forward rates calculated using IRP
and why?1. Nothing gives a ‘perfect’ forecast because there are so many factors that affect exchange rates. Inflation is regarded as a better predictor than interest rates because relative inflation rates have a more direct effect on demand for currencies than interest rates.
2. No. We use forward rates simply because that is was the bank is offering as the swap as stated in the question.
3. Always forecast rates using PPP. (Forward rates are not a forecast of future spot rates – they are simply fixed rates offered now by the bank calculated by the banks in the same way as per money market hedging (which is what the banks are doing) and therefore based on interest rates.)
Hello Mr John,
I would like to aologise in advance for the big post but I am really confused with this.
I have a question on futures. I asked you yesterday in regards to question Lirio Co whether we need to add or subtract the unexpired basis from the futures price. You said that the closing rate should be between the spot rate and the current futures rate as the basis reduces to zero. If we see the answer in Casasophia the solution says.
Future rate: 1.3698
Spot rate: 1.3618
So basis now is 0.0080
We have 1/5 unexpired basis so 1/5 * 0.0080=0.0016If we apply the rule that the spot and the futures rate must get closer we should deduct this amount from the futures price to get 1.3698-0.0016= 1.3682
Then we buy at the futures rate of 1.3698
We sell at 1.3682
So we have a loss of 0.0016We have 117 contracts so 117×125000×0.0016/1.3698=17082 euros loss.
The answer says instead that since futures rate – Spot rate is positive (0.0080) we need to add the 1/5×0.0080=0.0016 to the futyres rate so that 1.3698+0.0016=1.3714
In this way we have a profit of 17k
If we do it like this then the rates do not converge.
What is the correct way? Should they converge or when the futures rate minus the spot gives a positive we add to the futures rate and when futures rate minus spot rate is negative we deduct?
Thank you very much for your help and apologies again for the big post.
When I answered you yesterday I was assuming you were asking about the lock-in rate.
I don’t know which answer you are looking at, but the examiners answer calculates the lock-in rate to be 1.3682 just as you have typed in your post.
Where you are going wrong is that the lock-in rate of 1.3682 is not the futures price on the date of the transaction – it is the effective exchange rate that results from using futures (the combination of converting at the actual spot rate together with the profit or loss on the futures).
(To get the futures price on the date of the transaction you need to know the spot rate on the date of the transaction, because the actual futures price will be the actual spot rate as adjusted by the remaining basis.)
Thank you very much sir for your reply and all the help that you provide us.
Have a great weekend!
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