Links to all tutorial articles (same as those on the Exam pages)Calculating forward exchange rates - covered interest parity
An easy hit in the PRMIA exam is getting the question based on covered interest parity right. It will come with a couple of exchange rates, interest rates and dates, and there would be one thing missing that you will be required to calculate. This brief write up attempts to provide an intuitive understanding of how and why covered interest parity works. There are a number of questions relating to this that I have included in the question pool, and this article addresses the key concepts with some examples. All that ‘covered interest parity’ means is that investing in the domestic currency would be the same as investing in a foreign currency purchased at spot, and reconverting to domestic currency at the forward rate. A Swiss investor has CHF 1,000,000 to invest for a year. He is considering two options:
What covered interest parity says is that our investor would be equally well off in both the circumstances. Even if he could earn 3% in US dollars, any advantage he might get from this higher rate of interest would be offset exactly by a poorer exchange rate when he converts his USDs to CHF. If this were not to be true, and investing in dollars and converting back to francs later did indeed offer an advantage over investing in CHF, arbitrageurs would immediately borrow a large number of Swiss Francs, and convert them for investing in US Dollars while at the same time covering their future risk by entering into forward contracts. This would push the forward exchange rate in a way that there would be no money to be made from this trade.
In this case the forward rate will be
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