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The current spot exchange rate between 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?
A 1.4553
B 1.4379
C 1.4279
D 1.4451The Kaplan book has the answer as:
B
Applying 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 therefore 1,458.62/1,014.375 = 1.4379My issue here is that it doesn’t follow the formula.
The base currency is the sterling and hence should be 1.4415 x (5.75/4)/(4.75/4).
Are they correct and why?
They are correct, and you get the same answer using the formula.
The 3 month euro interest rate is 4.75/4 = 1.1875
The 3 month sterling interest rate is 5.75/4 = 1.4375Therefore the 3 month forward rate is 1.4415 x 1.011875/1.014375 = 1.4379
Have you watched my free lectures on this? The lectures are a complete free course and cover everything needed to be able to pass Paper FM well.
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