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Risk ManagementSection BRisk ManagementInterest Rate Parity

ACCA · Question 26.2 · Risk Management

Section B - Case 3: AeroFreight Logistics

Scenario: AeroFreight Logistics operates drone deliveries across Europe and Asia. The company is based in the UK (GBP). It owes a supplier €500,000 payable in 6 months.
Spot rate: €1.1500 - €1.1550 / £1
6-month forward rate: €1.1400 - €1.1460 / £1
UK 6-month borrowing rate: 4% (annual)
Euro 6-month deposit rate: 2% (annual)

Question 2: According to Interest Rate Parity (IRR), why is the Euro trading at a forward premium against the GBP?

Answer options:

A.

Because Euro interest rates are higher than UK interest rates.

B.

Because Euro interest rates are lower than UK interest rates.

C.

Because Eurozone inflation is higher than UK inflation.

D.

Because there is higher demand for Euros in the spot market.

How to approach this question

Recall the Interest Rate Parity theory: the currency with the lower interest rate will trade at a forward premium (it will become stronger in the forward market) to offset the interest rate differential.

Full Answer

B.Because Euro interest rates are lower than UK interest rates.✓ Correct
Interest Rate Parity (IRP) states that the difference in interest rates between two countries is equal to the expected change in exchange rates between their currencies. The currency with the lower interest rate (Euro at 2%) must trade at a forward premium against the currency with the higher interest rate (GBP at 4%) to prevent risk-free arbitrage.

Common mistakes

Assuming higher interest rates make a currency stronger in the forward market. In reality, higher interest rates lead to a forward discount.
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