Assume that interest rate parity holds. When a currency trades at a forward premium, what does that imply about domestic rates relative to foreign interest rates? What does it imply when a currency trades at a forward discount?
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Assume that interest rate parity holds. When a currency trades at a forward premium, what does that imply about domestic rates relative to foreign interest rates? What does it imply when a currency trades at a forward discount? |
Explanation
Interest rate parity implies that the investor should yield the same rate of return in their home country and foreign country even after adjusting the risk of foreign exchange rate. Spot rate is the current foreign currency market exchange rate. Forward rate is the predetermined rate at which currencies will be exchanged at a future date.
When a foreign currency (at a future date) can be exchanged with home currency at a higher value than the current exchange rate, it asserts that the forward rate is selling at a premium to the spot rate. In practical terms, it implies that a dollar buys less units of foreign currency in the forward market (i.e at a future date) as compared to the spot market (current date). For instance, if a dollar exchange rate is 80 Rs.(INR) per dollar at a current date, and at a certain future date, the exchange rate is only 70 Rs. per dollar, then such change is due to appreciation in foreign (here INR) currency. Thus, when the forward rate is sold at a premium to the spot rate it implies that the value of domestic currency has weakened with respect to the value of foreign currency.
On the other hand, a foreign currency (at a future date) can be exchanged with the home currency at a lower value than the current exchange rate. It is said that foreign currency is selling at a discount to the spot rate. In such a case, a dollar can buy more number of foreign currency units in the forward market, than in the spot market. For example, a dollar exchange rate is 75 Rs. (INR) per dollar in spot market, if foreign currency is trading at a discount, the future exchange rate will be more than 75 Rs. per dollar in forward market. Thus, when the forward rate is sold at a discount to spot rate, it implies that the value of domestic currency has strengthened with respect to the value of foreign currency.
Verified Answer
If interest rate parity holds, and a currency trades at a forward premium, it implies that domestic rates have depreciated in value with respect to foreign rates. On the contrary, if foreign currency is traded at a discount, it implies that domestic rates have appreciated in value with respect to foreign rates.
