Question

Based on the Covered Interest Parity (CIP), what should be the 90-day forward rate, F_£/US$, today on 6 April 2016 (the contract matures on 5 July 2016)? Use the exact equation of the CIP.??

2016-04-06

U.S. Dollars to One British Pound: 1.4162

3-Month Effective Interest Rate for U.S. Dollar: 0.15765

3-Month Effective Interest Rate for British Pound: 0.14703

Answer 1

Interest parity is a theoritical no arbitrage condition, where an investor will be indifferent between interest rates in different countries. Covered interest parity is when a forward contract on the foreign exchange market is used as a hedging tool to cover the arbitrage. There fore, an investor who looks to get profits out of higher interest rate in a foreign country will face a poor exchange rate nullifying his profits. In this case, the spot rate for GBP/USD is 1.4162

The 3 month interest rate on GBP IS 0.14703 and on USD is 0.15765

CIP is given as (1+i_?d?) = S/F*(1+i_?f?)

where, i_?d is the interest rate in domestic currency

i_?f is the interest rate on foreign currency

S is the current spot foreign exchange rate

F is the forward foreign exchange rate

we have to rearrange the formula to find the forward rate.

F = S * (1+i_?d? )/(1+i_?f ?)

Apply the values here,

F = 1.4162* (1+0.15765)/(1+0.14703)

= 1.4162*1.15765/1.14703

F=1.4293 is the forward rate