CFA Practice Question

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CFA Practice Question

The spot South Korean won/$ exchange rate is 833 won/$ and the one-year forward rate is 863 won/$. If the annual interest rate on dollar CDs is 9 1/2%, what would you expect the annual interest rate to be on won CDs?

A. 3.5%
B. 5.3%
C. 13.4%
Correct Answer: C

User Contributed Comments 19

User Comment
kunam [863*1.095/833-1]
stefdunk 1.095/(863/833)=1.0569
Rdom/Rfgn = Forward/Spot

it looks like the numbers are upside down 1.095/(833/863)=1.134
Rdom/Rfgn = Spot/Forward
cbb1 Stefdunk: The formula is Rdom/Rfgn = Forward/Spot.
The 9.5% is the Rfgn; thus, x/1.095 = 863/833 or x=1.095 times 863/833.
Hope this clarifies!
achu Remember, Don't assume US$ is domestic! Domestic is the numerator of the currency exchange rates. Won/USD here meanas Won is domestic, and 9.5% US i% is foreign as correctly pointed out by cbb1
alki the man..
bmeisner I think it's really important to conceptualize this. Simply put, if it costs more won to buy 1 USD in the future than currently then it must be that interest rates are higher in Korea. There will be more won earned from interest Korea to be equal to fewer dollars earned from interest in the US hence more won required to buy 1 USD in the future. Once you understand this concept it will be harder to get confused on the test.
VenkatB (F - S) / S = [(rb - ra)/(1 + ra)]
863-833/833 = rb - .095/(1.095)
so, rb = 13.44%
Allen88 For me, I rearrange the equation first to

{(F-S)/S}(1 + r1) + r1= r2

Then I fill in the F and the S first and try to think about what that means. Given the info above, since you can get more won in the future, that means that the dollar has appreciated. This tells me that the equation (F-S)/S means the percent appreciation of the dollar. So, from this I figure out that r1 should be the interest on the dollar. The 1 + r1 means that the appreciation will also earn the U.S. interest.
The whole interest rate parity thing seems to be saying that even if I take won, exchange it, and invest in an asset in the U.S., the combined effect of the U.S. appreciation times the interest earned on the appreciation and the interest earned in the U.S. should still be equaled to what I can earn investing in just the won CD.
charomano If B:A or A/B means Currency A per 1 unit of B
F/S=(1+Ra)/(1+Rb) => B should be in the denominator

In case we have 100,000 won in our hands. We have 2 choices: Invest in won or Invest in USD
1st Choice:
100,000 x (1+13.4%) = 113,400 won after 1 year exchanged at forward rate won 863/$=>$131.44
(Assuming the forward rate is the same as expected spot rate in efficient markets)

2nd choice:
Exchange 100,000 to spot rate => $120
We invest them at 9.5%=> 120(1+9.5%)=$131.44 in 1 year

Interest Rate parity assumes no arbitrage opportunites.
johntan1979 Be careful when you read the question...

It says spot rate is Korean won/$ = 833 won/$
NOT Korean won:$

Very easy to make mistakes when you mistaken the / for :
quanttrader F/S = (1+a)/(1+b). given S = b:a or a/b then a is Won and b is usd. Another way to think of it is since F/S = 863/833 > 1 then a > b and hence C is the only answer that makes sense.
Shaan23 Very Easy. Confusion is that we've been using D/F convention. Formula we need for this question is in F/D convention.
F/D = (1 + i(foreign) ) / (1 + i(domestic))

We are solving for 1 + i(domestic). In the questoin above the WON is domestic. The spot rate and forward rate are given as Domestic/Foreign the the left side of the equation is a forward rate the is Foreign over domestic. So invert the two numbers given.
Shaan23 ALso remember if by trick they gave you the monthly interest rate to adjust that. Say the 30 day interest rate = 5%

Use (1 + .05/30)
mkunkel28 Dollar is trading at a premium, which means Won is trading at a discount. Currencies trading at a discount carry a higher interest rate compared to the country with a currency trading at a premium. Only answer greater than 9.5% is C.
danubian good point, mkunkel
rodney176 I'm with mKunkel, the Won has to depreciate more than 9.5%...C...much less painful
davidt876 Shaan23 - assuming that 5% is an annual rate you mean "Use (1 + .05/12)".

Even if you assume you get 5% back after 30days then "Use (1 + .05*12)"

Also anybody know why they assume simple interest in the questions on interest rate parity?
davidt876 nvm just did the next question
MathLoser I want to show a very simple to you if you want to calculate.
=> KRW: Price currency.
=> USD: Base Currency

(forward / spot) = (1+ Interest price currency)/ (1+ Interest base currency)

With that, you will never fear domestic and foreign things anymore.
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