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Hi Sir, in Example 6 of the lecture notes for chapter 23, why do we take times 3/12 when finding the 3-months interest rate rather than using the formula (1+Y)=(1+M) ?
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A question to illustrate what I mean.
Bunga Co expects to receive E750000 from a customer in Europe in 6 months time. The spot rate is E/$ 2.330-2.349. The following interest rates are available :
Euros 4%-8% per year
Dollar 2%-3.5% per yearUsing interest rate parity(based on borrowing rate) what should be the 6 months forward rate?
The answer I got from using (1+Y)=(1+M) was almost similar but not the same and therefore would’ve been marked wrong under the system whose answer used simple interest and therefore just took 8%*1/2 to get the 6 months interest.
There is no such formula as (1+Y) = (1+M). It would be meaningless because it would mean that Y = M !!
For money market hedging the monthly interest rate used is 1/12 x the yearly interest rate. In my example it is 3 months and is therefore 3/12 of the yearly rate. In your example it is 6 months and is therefore 6/12 x the yearly rate.
I don’t know where you found the question Bunga, but there has been no past exam question with that name and neither in there a question with that name in the BPP Revision Kit.
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The formula that we use in early settlement discount to count the yearly rate, couldn’t we use that to calculate the 6 monthly interest rate? Therefore it would be (1+8%)^(1/2) -1= 6 monthly rate. The answer for this question was 2.401 whereas if I used that formula it would be 2.399.
I know that is the formula you mean, but that was not what your typed!!
However I have answered your question. For money market hedging the monthly rate is 1/12 of the annual rate.
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Yes I understand that is how we calculate the monthly rate. But it begs the question of why as if we were trying to forecast a 2 year forward rate using the IR Parity formula we would compound it by 2 but when we’re trying to forecast a 6-monthly rate we assume that it doesn’t compound?(I’m assuming that the (1+8%)^(6/12)-1 is to find a compound monthly rate)
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