Reading Covered Interest Parity and Currency Forward Quotes

Summary

The document examines a covered interest parity example involving Australian and US interest rates and a spot exchange rate quoted in US dollars per Australian dollar. The example applies the rate differential over the contract term to derive a forward exchange rate. The questioner interprets being long the AUD/USD forward as a bet on the Australian dollar appreciating, then wonders why the formula's rate relationship appears inconsistent with the intuition from borrowing US dollars to buy Australian dollars.

The central learning issue is the distinction between the forward price implied by funding rates and a directional forecast of the future spot rate. The quoted forward embeds the relative carry from holding and funding the two currencies; it does not by itself say which currency will appreciate or make a profit guaranteed. The document poses this conceptual confusion but includes no answer, so it does not resolve quotation conventions, cash flows, or the difference between a forward position and a funded spot trade. The numerical example illustrates the question rather than serving as empirical evidence.

Key ideas

• Covered interest parity relates a currency forward rate to the spot rate and the two currencies' interest rates.
• The exchange-rate quotation convention determines how the rate differential appears in the forward formula.
• A long currency forward position is not equivalent in every respect to borrowing one currency and investing in another.
• The forward rate reflects relative funding carry and is not, by itself, a prediction of future spot appreciation.
• The document raises the issue but does not include a resolution or a cash-flow derivation.

Tags

# confusion about the covered interest rate parity formula


# confusion about the covered interest rate parity formula












> Example 5.6 Suppose that the 2-year interest rates in Australia and the United States are 3% and 1%, respectively, and the spot exchange rate is 0.7500 USD per AUD. From equation (5.9), the 2-year forward exchange rate should be $$ 0.7500 e^{(0.01 - 0.03) \times 2} = 0.7206 $$

Above is an example from Hull's Options and Derivatives book on applying the standard covered interest parity formula. It seems to me that if an investor was long the AUD/USD forward (which I believe means betting on AUD to increase in value versus the USD), the covered interest parity formula suggests that he/she would want the AUD rate to decrease compared to the USD.

But that doesn't make sense to me. If someone is borrowing USD to buy AUD, it seems that they should want AUD's interest rate to increase and USD's to decrease. What am I missing?

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.