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Hello sir,
I have a doubt related to the question below.(Kaplan exam kit)
The current spot exchange rate betwn sterling and euro is sterling 1.4415/euro. The sterling annual interest rate is 5.75% and the euro annual interest rate is 4.75% pa.
What should be the 3 month sterling/euro forward rate be (4 decimal places)?
The answer states it to be 1.4379 sterling/euro.
Solution: apply interest rate parity:
Invest 1000 euro at 5.75percent for 3 months= euro 1014.375
Convert euro 1000 to sterling at 1.4415= sterling 1441.5
Invest that at 4.75% for 3 mnths= sterling 1458.62
Implied forward rate is 1458.62/1014.375=1.4379But sir my doubt is that y dont we just simply apply interest rate parity formula like this? 1.4415*(1.014375/1.011875) and get 1.4451.
Thank you Sir!No problem – it gives the same answer and it does not matter how you get the answer.
As I explain in my free lectures, the interest rate parity formula is applying what we do with money market hedging – it will always give the same result.
So Sir, does it mean that 1.4379 and 1.4451 both are correct? Just asking because the question wants the answer to 4 decimal places but I am getting the last three places different!
Sorry – I answered your previous question too quickly.
You can use the interest rate parity formula, but since the question is asking for the 3 month forward rate you need to use the 3 month interest rates – you have used the annual interest rates.
The three month rates are 5.75/4 = 1.4375% for euros, and 4.75/4 = 1.1875% for sterling.
So using the formula gives: 1.4415 x (1.011875/1.014375) = 1.4379
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