CFA Level II ExamDerivativesMedium
A currency trader is analyzing the implied forward rate for the EUR/USD exchange rate using covered interest parity. The spot exchange rate is 1.1000 USD/EUR. The 90-day USD interest rate is 1.50% (annualized) and the 90-day EUR interest rate is 0.50% (annualized). Assuming 360 days in a year, what is the 90-day forward exchange rate (USD/EUR)?
- A1.1027 USD/EUR
- B1.0973 USD/EUR
- C1.1054 USD/EUR
- D1.1000 USD/EUR
Show answer & explanationAnswer & explanation
Correct answer: A. 1.1027 USD/EUR
Using the covered interest parity formula, F = S * (1 + r_domestic * (days/360)) / (1 + r_foreign * (days/360)), where F is the forward rate, S is the spot rate, r_domestic is the USD rate, and r_foreign is the EUR rate. F = 1.1000 * (1 + 0.0150 * (90/360)) / (1 + 0.0050 * (90/360)) = 1.1000 * (1.00375) / (1.00125) = 1.102747 USD/EUR.
Why the other options are wrong
- B. Incorrect; possibly inverted interest rates or incorrect calculation.
- C. Incorrect; calculation error, possibly using annual rates directly or incorrect formula application.
- D. Incorrect; this is the spot rate, not the forward rate.
Covered Interest Parity (CIP)
Covered Interest Parity is a no-arbitrage condition that links spot exchange rates, forward exchange rates, and interest rates in two different currencies.
- It implies that the return on a hedged foreign investment should equal the return on a domestic investment.
- The formula is F = S * (1 + r_domestic * (T/360)) / (1 + r_foreign * (T/360)).
- It assumes perfect capital mobility and no transaction costs.
Memory trick: CIP: Spot * (1 + Domestic) / (1 + Foreign) for Forward!