# Forward Exchange Rates

There are two neighbouring countries; Ankland and Barnam. Currently, their currencies are trading at par. The risk-free rate in Ankland is 4% and the risk-free rate in Barnam is 6%. According to interest rate partiy, the analyst would expect that…

a. Ankland’s currency will depreciate and Barnam’s currentcy will trade at a premium in the forward market.

b. Ankland’s currency will appreciate and Barnam’s currency will trade at a premium in the forward market.

c. Ankland’s currency will appreciate and Barnam’s currency will trade at a discount in the forward market.

The answer is apparently C. However, I chose A because if the interest rate in Barnam is 6%, surely investors are going to invest at the higher rate of 6% and this will appreciate the currency?

Suppose that the current (spot) exchange rate is ANK/BAR 2.0000. Then the forward rate is:

ANK/BAR 2.0000 × (1.04)/(1.06) = ANK/BAR 1.9623

Thus, it will take fewer ANK to buy one BAR in the future: the ANK will appreciate. And you’ll get fewer ANK for one BAR in the future, so the BAR trades at a forward discount.

Sounds like C).