- France short-term interest rate = 3.2% UK short-term interest rate = 4.7% Forward discount on the pound = 4.7% - 3.2% = 1.5% So the higher interest rate currency is at a forward discount. 2. Current forward rate = Euro1.60/Pound1 Spot exchange rate = Euro1.75/Pound1 Forward discount on the pound = (1.60 - 1.75) / 1.75 = - 8.57% So the British pound is trading at a forward discount. Can someone please explain how these are linked? Part 1 says the higher interest rate currency is at a forward discount and then part 2 says the lower forward exchange rate is a forward discount but I’m getting confused here?
1.75 x 1.032 / 1.047 gives similar to fwd rate (o dont have calculator at my hand now).
F(P/B) = S(P/B) × (1 + rP) / (1 + rB)
For the first example,
F(EUR/GBP) = S(EUR/GBP) × (1 + rEUR) / (1 + rGBP)
= S(EUR/GBP) × (1 + 3.2%) / (1 + 4.7%)
= S(EUR/GBP) × 0.9857
So GBP has a higher risk-free rate and is trading at a forward discount (vis-à-vis EUR), and, consequently, EUR (with a lower risk-free rate) is trading at a forward premium (vis-à-vis GBP).
In the second example,
F(EUR/GBP) = S(EUR/GBP) × (1 + rEUR) / (1 + rGBP)
1.60 = 1.75 × (1 + rEUR) / (1 + rGBP)
1.60 / 1.75= (1 + rEUR) / (1 + rGBP)
0.9143 = (1 + rEUR) / (1 + rGBP)
0.9143(1 + rGBP) = 1 + rEUR
rGBP > eEUR
So GBP has a higher risk-free rate and is trading at a forward discount (vis-à-vis EUR), and, consequently, EUR (with a lower risk-free rate) is trading at a forward premium (vis-à-vis GBP).
No problem.