Let’s say we have INR/USD = 70
USD Int Rate for next year is 2%
India Int Rate for next year is 6%
In Core there is a statement – “The bias in the “Forward Rate Bias” is that the premium typically overstates the amount of appreciation of the base currency & the discount overstates the amount of depreciation”
I have understood that in short term the UIRP doesn’t hold good and the high yield currency appreciates instead of depreciating. I can’t get my head around it that, how premium typically overstates the amount of appreciation of the base currency & the discount overstates the amount of depreciation.
Please clarify it using the above INR/USD Exchange Rate & Interest Rates.
We know that in the short run UCIRP does not hold. This means that the high yielding currency does not depreciate as much as the forward rate expects it to depreciate. This line can mean either of the following: (a) the high yielding currency appreciates instead of depreciating, or (b) the high yielding currency depreciates less than expected by the forward rate. This means that the forward discount that is reflected in the forward rate regarding this high yielding currency overstates the amount of depreciation because the depreciation is either going to be less than expected or there won’t be any depreciation. In fact, there may be an appreciation in the currency. This way, the forward discount overstates the amount of depreciation in the high yielding currency.
Similarly, the low yielding currency may not appreciate as much as expected. This implies that either the low yielding currency will (a) appreciate less than expected by the forward rate, or (b) depreciate instead of appreciating. In both scenarios what is certain is that the forward premium in the forward rate for the currency overstates the amount of appreciation.