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FX forward rate should reflect the difference in the interate in the two currencies.

At the moment GBP USD is trading near 1.29. The 5 year yield for US treasuries is about 1.87% and the UK 5 year gilt is currently yielding about 0.5%. This we would expect this is reflected in the GBP USD forward rate. We should expect the 5 year GBP USD rate to be lower than the current rate.

However, the current GBPUSD forward quotes I am seeing is:

Period GBPUSD

SPOT 1.2848

M12 1.299483

Y2 1.3175

Y3 1.336775

Y4 1.356516

Y5 1.3755

Y6 1.3933

Why is there a discrepancy? Why is there no arbitrage? Is my reference rate wrong?

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    $\begingroup$ A rule of thumb for a rookie FX trader: "The higher interest currency is seen to depreciate in the forward market". That is exactly what we see in this data: Higher i.r. in US and a weaker dollar in the future (increasing GBP price as maturity increases). $\endgroup$ – noob2 Apr 27 '17 at 16:54
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I am assuming you are confused because you expect the USD to be stronger with the higher interest rates.

I had the exact same issue as you just a few months ago. The simplest way to clarify this is that the forward market is created on a NO arbitrage basis.

By logic, we assume that the country with the higher interest rates attracts more foreign investments and thereby appreciating that country's currency. The forward market is there to prevent arbitrage opportunities like this where you can invest in the higher interest rate country and simultaneously hedge your exchange exposure by going into a forward contract that allows you to exchange back into your own currency for higher interest profits.

By arbitrageurs who look to do this, the forward market should have high demand for GBP/USD (they are trying to lock in rates) and therefore GBP/USD increases instead of lowers. The calculation of forward prices takes this into account and that is why you have forward rates that do not align with your expectations.

Note also that forward rates are by no means an indication of future prices. They are simply there mostly as a hedging tool. The currency with the higher interest rates can most definitely end up appreciating against against the lower interest rate currency even though the forward markets says otherwise. For more information on this you can do a google search on Japaneses Yen against USD which is an interesting read.

The issue you question here can be found here -http://www.investopedia.com/terms/u/uncoveredinterestrateparity.asp

I suggest you read through BOTH covered and uncovered interest rate parities to fully understand.

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  • $\begingroup$ Let's look at some numbers. With interest rates equal to 1.87% and 0.5%, the 5 year gross returns are 1.0970629 and 1.02525125. Multiplying the spot rate of 1.2848 by the ratio of these two we get a predicted 5 year forward of 1.3748 which is close (though not identical) to the observed 1.3755 $\endgroup$ – noob2 Apr 28 '17 at 12:57

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