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Inside the Currency Market: Mechanics, Valuation, and Strategies by Brian Twomey

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Outright Forwards

The method to connect interest rate swap conditions is to employ forward-implied rates. The forward price of a currency must relate to an interest-rate differential between two currencies. The classic definition says it assumes an arbitrage condition is possible if parity doesn't exist.

A formula to look at this relationship is:

image

where

ti* = foreign period nominal interest rate,

it = domestic period interest rate,

st = spot rate (foreign to domestic in logs),

set+1 = market one step ahead forecast for the spot rate at t, and

pt = risk premium.

This formula captures bond-yield differentials that reflect expected exchange-rate ...

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