Interest Rate Parity

[AndrV]

Hi All,
IRP for a/b currency pair says Forward = Spot * 1+Ra/1+Rb
In the case where Forward > Spot * 1+Ra/1+Rb, the forward is overpriced.
Therefore you would sell b (lend at Rb) and buy a (borrow at Ra). (My understanding)
Kaplan refers to this situation as money flowing out of the domestic market.
My questions are :
1. Is my understanding of an overpriced forward correct?
2. Does money flowing out of the domestic market means that money is flowing away from dealers portfolios?

Thanks for any help.
A

 

[S2000magician]

AndrV wrote:Hi All,
IRP for a/b currency pair says Forward = Spot * 1+Ra/1+Rb
In the case where Forward > Spot * 1+Ra/1+Rb, the forward is overpriced.
Therefore you would sell b (lend at Rb) and buy a (borrow at Ra). (My understanding)
Kaplan refers to this situation as money flowing out of the domestic market.
My questions are :
1. Is my understanding of an overpriced forward correct?

Yes. If you’re going to end up with more of currency a than you should, you want to start by borrowing currency a.

AndrV wrote:2. Does money flowing out of the domestic market means that money is flowing away from dealers portfolios?

I’m not sure that I understand the question. You’re borrowing one currency, converting it to another currency, then investing that new currency. One currency goes out, another comes in.

 

[AndrV]

Thank you S2000. (Was hoping for you to answer)
Regarding question 2, I made the mistake of thinking selling/buying are simultaneous transactions rather than converting first.
Many thanks.
A

 

[S2000magician]

You’re welcome.

 

[Anand Singh]

Short b in the forward market and buy B in the spot market (by borrowing “a” and converting it to “b” in the spot market)