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The current spot exchange rate between the sterling and the euro is €1.4415/£. The sterling three month interest rate is 5.75%pa and the euro three month interest rate is 4.75%pa.
What should the three month €/£ forward rate be to four dp?
Answer
Using interest rate parity
Invest £1,000 at 5.75% for three months (0.0575/4) = £1,014.375
Convert £1,000 to € at 1.4415 = €1,441.5
Invest that at 4.75% for three months (0.0475/4) = €1,458.62
Implied forward rate is 1,458.62/1,014.375 = 1.4379I have no idea what’s happening here.. Please throw some light.
You need to watch my free lectures on money market hedging, because it is money market hedging that determines the forward rate.
(Although you could of course use the interest rate parity formula on the formula sheet, which is derived from money market hedging).
I have watched all of them and I understand what you did.. I just didn’t know the question was asking for an application of money market hedging technique..
Is this possible in the exam? Where we may not be told which technique to use and we have to decide which to use?
Yes it is possible in the exam, although it is easier just to use the interest rate parity formula that is given on the formula sheet. (Only the answer is marked – nobody will look at your workings)
It is always interest rate parity (which is the same as money market hedging) that gives the forward rates – there is no other technique to get forward rates.
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