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Hello.
My class test question was as follows:a) Derive the covered interest rate parity. (10 marks )
b) One year borrowing and deposit rates are 13% and 12% respectively in the US and 12% and 8.5% respectively in France. The spot exchange rate for the US dollars is $24 to the EURO. The 12-month forward rate is $24.66
i) Using the derived formula in a) above, determine show that there is a break down in the parity conditions. (3 marks )
ii) Suggest a way you might profit from the pricing inconsistency presented here, assuming you have no initial funds. ( 8 marks )
For question a), i wrote :
Forward rate = Spot rate x (1 + interest rate foreign)/ (1 + interest rate domestic) ^n
and i don’t know what else to write for 10 marks.b) i) Forward rate = Spot rate x (1 + interest rate foreign)/ (1 + interest rate domestic) ^n. I received 24.21 dollar to euro
For b ii) I failed to answer the question.
Thank you in advance for answering.
I will answer you (although I don’t usually answer in this forum – this forum is for students to help each other. I answer in the Ask the Tutor Forum 🙂 )
Part (a) could not be asked in Paper PM because you are given the formula in the exam. However, it is derived using the money market hedging technique (as explained in my free lectures, but using symbols for the interest rates rather than actual numbers). Simply stating the formula is not deriving it.
For b(ii), given that the actual forward rate is not the same as it should be using money market hedging, you could use money market hedging and then at the end of the period convert back at the forward rate – that was you would make a profit out of it.
Do watch my free lectures on foreign exchange risk management.
Thank you for replying and sorry I didn’t know about it. Will be cautious next time.
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