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I am going through the answer of Q2 but I don’t how to apply rates when they are expressed as 8.7% basis rates or 2.2% etc.
also, I am not clear on the computation of the forward rate or why has it been divided by 3?
Same applies for the premium computation for the option. I know how to compute a premium but in this question the cost has been multiplied by a reinvestment rate (which I don’t know where it was obtained)
I don’t know what you mean by basis rates! Are you meaning basis points? 1 basis point means 0.01%
Interest rates are always quoted as annual rates. So if you are borrowing/depositing for 4 months, then the actual interest will be 4/12 of the annual interest rate.
The forward rate is calculated using the interest rate parity formula that is given on the formula sheet.
There is no mention of a reinvestment rate in either the question or the answer!
What I think you are talking about is that because the option premium is payable immediately we will either have to borrow money (and therefore pay interest – the borrowing rate) or, if we already have the money, then lose interest that we could otherwise be receiving – the investment or deposit rate. The examiner allowed you to use either rate because it depends on your assumption.
This is an excerpt from the question
“The first derivative product is an over-the-counter forward rate determined on the basis of the Zuhait base rate of 8·5% plus 25 basis points and the French base rate of 2·2% less 30 basis points. current spot exchange rate of ZP142 per €1. ”This is the answer “Using forward rate
Forward rate = 142 x (1 + (0·085 + 0·0025)/3)/(1 + (0·022 – 0·0030)/3) = 145·23”why do we divide by 3 and why do we divide by the French basis points?
It is as exactly as i wrote in my previous answer.
It is using the interest rate parity formula, so you multiply the spot rate by (1 + zhuhai interest rate) / (1 + French interest rate)
The Zuhait rate from the question is 8.5 + 0.25 = 8.75%, and the French rate from the question is 2.2% – 0.3% = 1.9%
These are annual rates, so because we are looking at a period of 4 months, the interest for 4 months is 4/12 of the annual rate. 4/12 = 1/3.
Is it not true that the interest rates are not the predictor of forward rates? i.e we can not use them to predict the forward rate?
Relative interest rates are what determine forward rates.
I think that you maybe confusing with future spot rates. It is impossible to predict future spot rates – in the exam, inflation rates are used as the best predictor.
However forward rates are not a ‘guess’ by the bank – they calculate the forward rate to offer by using interest rates.
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