(Help) Interest Rate Parity

[mountaincloud]

Hi, guys, I am confused a little bit here.

Q) Assume the Philippine peso is at a 1-year forward discount of 1.25% to the Thai baht and that Thailand's 1-year interest rate is at 3.00%. If a Thai investor has no arbitrage opportunities, the Philippine interest rate is closest to:

A) 4.25
b) 1.75%

Which one is correct why?

Thx

 

[jamespucyk]

According to Linear Approximation:
F-S = rDC - rFC

First step determine the appropriate rate (which you should ALWAYS do for Exchange questions). That is Peso/Bhat as stated in the question So DC is the Peso and the FC is the Bhat.

Then note that since the future is at a discount then the Philipines must have a lower interest rate, hence B, 1.75%. or mathematically:

F-S =
-1.25 = rDC - 3%
3 - 1.25 = 1.75 = rDC

 

[jamespucyk]

I don't think we have to know anything for linear approximation for Level 1 however.

 

[mountaincloud]

Actaully, it's from Schweser note (Concept Checkers), and according to Schweser the answer is 4.3%.

I thought it's 1.75% and that's why I was confused.

 

[dynamic_hedger]

The answer should be 4.25%.

It's important to understand this intuitively rather than memorizing formulas. That way, there's no need to deal with this business of FC/DC, etc., which can be confusing and leads to mistakes.

In equilibrium, a Thai investor should be indifferent between investing at home or investing in the Phillipines. After all, if the prospective return in the Phillipines was more attractive, then Thai investors would invest money there until the forward prem./disc. adjusts to bring about equilibrium.

Then, we must have:

Thai nom. interest rate (T) = Phillipine nom. interest rate (P) + forward disc/prem. (F)

This is an approximation of the familiar covered intererst parity relationship.

Plugging into the equation:
3% = P - 1.25%
P = 4.25%