Spot and Forward Rates [LO1] Suppose the exchange rate for the Swiss franc is quoted as SF

Spot and Forward Rates [LO1] Suppose the exchange rate for the Swiss franc is quoted as SF

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July 20, 2022
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Spot and Forward Rates [LO1] Suppose the exchange rate for the Swiss franc is quoted as SF 1.50 in the spot market and SF 1.53 in the 90-day forward market.
a. Is the dollar selling at a premium or a discount relative to the franc?
b. Does the financial market expect the franc to strengthen relative to the dollar? Explain.
c. What do you suspect is true about relative economic conditions in the United States and Switzerland?

Answer and ExplanationSolution by a verified expert

a
Here is a tip:
A currency is said to be traded on premium if it is more expensive in the future.

Explanation
A currency is said to be selling at a premium when its forward exchange rate is more than the spot exchange rate. In this case, the spot exchange rate of a dollar is SF 1.50, whereas the 90-day forward exchange rate of dollar is SF 1.53. Thus, the dollar is trading at a premium relative to the franc.

Verified Answer
The dollar is selling at a premium relative to the franc because its forward exchange rate of SF 1.53 is more than the spot exchange rate of SF 1.50.

b
Here is a tip:
If more of a particular currency is required to buy another currency, then the value of that particular currency will fall.

Explanation
The financial market expects the franc to depreciate relative to the dollar in the near future. For this reason, the forward exchange rate of the dollar in terms of the Swiss franc at SF 1.53 is higher than the spot exchange rate of SF1.50.

Verified Answer
On the contrary, the financial market expects the franc to depreciate relative to the dollar as more francs will be required to buy a dollar in the near future.

c
Here is a tip:
The lower value of a currency compared to other currency depicts poor economic conditions.

Explanation
The selling of the dollar at a premium relative to the franc reflects that in the near future, more francs are required to buy a dollar. This is indicative of the higher inflation rate and interest rate in Country S compared to Country U.

The higher inflation rate in Country S decreases the value of the franc, and thus more francs are required to buy a dollar. The interest rates are also higher in country S since the government increases the interest rates to control the inflation rate.

Verified Answer
The relative economic conditions in Country U and Country S indicate that the inflation rate and interest rate are higher in Country S compared to Country U.

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