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Tuesday, September 30, 2008

guessing IR differential from FX fwd points

See post on the equation between forward/spot FX and IR differential.

Q2: why do you subtract in the descending case but add in the ascending case?
A: because offer price must exceed bid price. If we were to add in the descending case, then spot bid (lower) + forward bid points (larger) might EXCEED spot offer (higher) + forward offer points(smaller)

Q: If you see positive forward points like eur/usd 1mth = 11/12 (ascending order [1]), which currency earns higher interest for the next month?

A: remember IR parity principle {{{ convert-deposit = deposit-convert }}}. Remember Euro is now cheaper and appreciating.

A1a: Say you start with a bunch of Euros. converting now (unfavorable) then deposit (must be favorable to compensate). So USD interest must be higher.
A1b: deposit (?) then convert (favorable). So the Eur deposit return must be lower to even up.

A2a: Say you start with a bunch of dollars. convert (economical) then deposit (must be unfavorable), so Eur deposit must be inferior
A2b: deposit (?) then convert (costly). So USD deposit return must be higher to compensate.

Conclusion -- either deposit->convert or convert->deposit, the 2 legs must cancel out each other's advantages.

Important observation -- When forward points are ascending, FX rate is rising. Therefore first currency (the "silver") appreciating. In such a context, first currency IR is lower than 2nd currency.

Intuitively, deposit->convert will even out since it's unfavorable->favorable.

[1] If you see descending order like 12/11, then forward is lower than spot [2] i.e. First currency (the "silver") is now expensive and depreciating. First currency IR must be higher than 2nd currency.

Intuitively, depost->convert is  favorable->unfavorable