What is the difference between spot rates and forward rates? When is the foreign currency forward rate selling at a premium to the spot rate? At a discount?

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What is the difference between spot rates and forward rates? When is the foreign currency forward rate selling at a premium to the spot rate? At a discount?

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With the growth in demand for exotic foods, Possum Inc.’s CEO Michael Munger is considering expanding the geographic footprint of its line of dried and smoked low-fat opossum, ostrich, and venison jerky snack packs. Historically, jerky products have performed well in the southern United States, but there are indications of a growing demand for these unusual delicacies in Europe. Munger recognizes that the expansion carries some
risk. Europeans may not be as accepting of opossum jerky as initial research suggests, so the expansion will proceed in steps. The first step will be to set up sales subsidiaries in France and Sweden (the two countries with the highest indicated demand), and the second is to set up a production plant in France with the ultimate goal of product distribution throughout Europe.
 
Possum Inc.’s CFO, Kevin Uram, although enthusiastic about the plan, is nonetheless concerned about how an international expansion and the additional risk that entails will affect the firm’s financial management process. He has asked you, the firm’s most recently hired financial analyst, to develop a 1-hour tutorial package that explains the basics of multinational financial management. The tutorial will be presented at the next board of directors meeting. To get you started, Uram has supplied you with the following list of questions:
f. What is the difference between spot rates and forward rates? When is the foreign currency forward rate selling at a premium to the spot rate? At a discount?

Explanation & AnswerSolution by a verified expert

Explanation

Spot rate is the present price paid to purchase a foreign currency, for its immediate delivery. There should be a negligible time gap between the purchase and delivery of the currency. Forward rate is the rate which is agreed to be paid, to buy foreign currency which would be delivered at a certain future day. Spot rate is always known as it is the current market exchange rate. Forward rate can only be an estimated rate as it is subject to fluctuations, depending upon changes in bilateral trade between the countries.
 
Forward rate contracts may be selling at premium, or at a discount to the spot rate.
 
When the value of the foreign currency in comparison to the home currency is appreciating, it asserts that the forward rate contract is selling at 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 70 Rs. (INR) per dollar at a current date, and at a certain future date, the exchange rate is only 60 Rs. per dollar, then such change is due to appreciation in foreign (here INR) currency.
 
On the contrary, if the foreign currency value depreciates in comparison to the domestic currency, 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 (INR) is trading at a discount, the future exchange rate will be more than 75 Rs. (INR) per dollar in forward market.

Sample Response

Spot rate is the present foreign currency market exchange rate. Forward rate is the predetermined rate, at which currencies will be exchanged at a future date. Forward contract is selling at a premium, when the predetermined future exchange rate is more than the current spot rate. When the spot rate is more than the predetermined exchange rate, the forward contract is supposed to be trading at discount.

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