Money, Banking, and International Finance
360
1
360
1
T
+i
T
+i
F=S
f
d
(29)
We can use an approximation to simplify the equation in Equation 30.
360
1
T
F S +id if (30)
We can derive another equation to solve for the interest rates, yielding Equation 31.
360
T
i i
S
F S
d f
(31)
For example, the interest rate in the United States is 5% and 3% for Malaysia. If the spot
U.S. dollar-Malaysian ringgit exchange rate equals $0.3333 per ringgit, then we price a six-
month forward contract for $0.3366 per ringgit. Thus, investors believe the Malaysian ringgits
will appreciate roughly 1% while the U.S. dollar will depreciate. This sounds counter intuitive
because investors are attracted and want to earn the greater interest rate. However, this analysis
assumes arbitrage brings the two investments into equality. If the interest rates differ between
two countries, the country with a higher nominal interest rate must greater inflation that would
depreciate its currency. Therefore, this analysis assumes a country with a higher interest rate
possesses a depreciating currency.
We can reverse our logic to yield an identical equation to Equation 29. At time t, we borrow
from a foreign bank one unit of a foreign currency for T days. When we repay the bank loan on
Time T, we pay the foreign bank the following units of the foreign currency in Equation 32.
360
1
T
+if (32)
At time t, we exchange one unit of foreign currency for the domestic currency; therefore,
we multiply by the spot exchange rate S. At time t, we deposit the domestic currency, S, into a
domestic bank for T days and earn the domestic interest rate, shown in Equation 33 :
360
T
S 1 +id (33)