I am struggling with this one.
One year ago, the currency of Xyland (XYZ) was at a three-month forward premium to the currency of Piqua (PQR). Today, the XYZ is at a three-month forward discount to the PQR. Assuming the interest rate parity relationship holds, this change implies that:
A) the XYZ has depreciated relative to the PQR.
B) today the XYZ three-month interest rate is higher than the PQR three-month interest rate.
C) one year ago the XYZ three-month interest rate was higher than the PQR three-month interest rate.
I jus’t dont know where to start. The answer is B)
The forward premium/discount tells you what is expected to happen in the future, not what has happened in the past. Therefore, A) cannot be correct: we have no information on what’s happened in the past.
To say that XYZ was trading at a 3-month forward premium to PQR means that the 3-month PQR/XYZ forward rate was higher than the PQR/XYZ spot rate (translation: in the future, XYZs will buy more PQRs than they will today). This means that the PQR interest rate was higher than the XYZ interest rate. Therefore, C) is incorrect.
To say that XYZ is trading at a 3-month forward discount to PQR means that the 3-month PQR/XYZ forward rate is lower than the PQR/XYZ spot rate (translation: in the future, XYZs will buy fewer PQRs than they will today). This means that the PQR interest rate is lower than the XYZ interest rate. Therefore, B) is correct.
I need to write an article on this.
Great, I almost there. Just need to understand the connection with interest rates.
If currency A buys more than currency B, then currency B interest rate is higher?
If currency B buys more than currency A, then currency A interest rate is higher?
Almost there…I think…
I remember tripping over the same exact question. I misunderstood “The XYZ is at a premium to PQR” and thought PQR was the base while in fact it’s the opposite. If you can remember that when we say “X is at a premium/discount to Y” and understand we’re talking of Y/X exchange rate, you will be fine, since you should know from the interest rate parity that:
F = S ((1+iY)/(1+iX))