Chartered Financial Analyst (CFA) Practice Exam Level 2

Currency forward contracts are often priced using the interest rate parity theory, which reflects the relationship between spot exchange rates, forward exchange rates, and the interest rates of the two currencies involved in the contract. The correct expression captures this by stating that the forward rate (F0) is equal to the current spot rate (S0) adjusted for the interest rates of the domestic currency (DC) and foreign currency (FC) over a defined time period (T).

In the formulation given, the term [(1 + I(DC))/(1 + I(FC))]^T represents the adjustment made to the spot rate based on the differential between the interest rates of the two currencies. This adjustment accounts for the cost of holding the currencies and effectively connects the future value of one currency in terms of another to the prevailing interest rates. Hence, it provides a method for calculating the expected future exchange rate, which is critical for the valuation of forward contracts.

This formula demonstrates how forward contracts ensure that the return on investments in different currencies is equal when adjusted for the interest rates, thereby preventing arbitrage opportunities in the foreign exchange markets. Therefore, the power of this relationship within the field of finance is crucial for practitioners and investors who seek to hedge against currency risk.