interest rate parity question discount, somebody, interest, question

sabaruch

I would appreciate if somebody can help me with this problem:
This is one of the problems from the Schweser note (Assigned reading 18 question 10)
Question:
Assume the Phillipine peso is at a 1 year forward discount of 1.25% to the Thai baht, and Thailand`s 1 year interest rate is at 3%. If a Thai investor has no arbitrage opportunities, the Phillipine interest rate is closest to:
A, 4.25%.
B, 1.76%
C, 1.25%
Answer:If there are no arbitrage opportuniites, IRP holds, and the interest rate differentila is equal to the forward differential ( i understand this).Since the PHP is trading at a forward discount, PHP interest rate must be greater than THB interest rate.
Thanks

jbaldyga

Thai Baht f = -1.25%
Thai I = 3%
f = Thai I - Philline I or -1.25 = 3 - X
solve for X: X = 3 - (-1.25) = 3 + 1.25 or 4.25%
since the PHP is a discount, f is a negative #.
Does that answer your Q?

Chuckrox8

Not really, i guess i am a little slow on this!

koba

Forward discount = 1.25% means
(F - S) / S = -1.25%
or rearrange above gives you: F / S = 98.75% (100% - 1.25%)
obviously because this is a discount, this % should be
Remember your formula:
F / S = (1 + Rc) / (1 + Rb)
Where F and S quoted as Base:Counter (peso to baht, so peso = base)
Rc = interest rate of “counter”
Rb = interest rate of “base”
so 98.75% = (1+3%) / (1 + Rb)
Rb = 4.30%
the above was the EXACT calculation. The approximation is the following:
forward differential = interest rate differential
-1.25% = Rcounter - Rbase (once again Rcounter is baht because we’re given “peso to bach, i.e., Peso:Baht)
-1.25% = 3% - Rbase
Rbase = 4.25%

towardsutopia21

Thanks a lot!If you are in midtown I get you a beer! I think its awsome you post something and somebody answers it in a day!