Question When is a foreign currency most likely trading at a forward premium? When the forward rate expressed in the domestic currency is below the spot rate. When the forward rate expressed in the domestic currency is above the spot rate. Solution The correct answer is B. Subscribe to our newsletter and keep up with the latest and greatest tips for success. Our videos feature professional educators presenting in-depth explanations of all topics introduced in the curriculum.
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Forward premium or discount is normally expressed as annualized percentage of the difference. It shows that the foreign currency has appreciated because it will take more units of the domestic currency to buy one unit of the foreign currency. An appreciation for foreign currency is the depreciation for domestic currency; hence, when the foreign currency trades at a forward premium, the domestic currency trades at a forward discount and vice versa.
It means that right now it takes 0. It shows that the foreign currency i. We can use the following formula to work out the percentage forward premium or discount for the foreign currency, i. When the result is positive, it is a forward premium and when its negative, it is the forward discount. When the indirect quote is used i. You are welcome to learn a range of topics from accounting, economics, finance and more.
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But not all ch It is merely the expectation that it will happen because of the alignment of the spot, forward, and futures pricing. Typically, it reflects possible changes arising from differences in interest rates between the currencies of the two countries involved.
Forward currency exchange rates are often different from the spot exchange rate for the currency. If the forward exchange rate for a currency is more than the spot rate, a premium exists for that currency. A discount happens when the forward exchange rate is less than the spot rate. A negative premium is equivalent to a discount. The basics of calculating a forward rate requires both the current spot price of the currency pair and the interest rates in the two countries see below.
Consider this example of an exchange between the Japanese yen and the U. In this case, the dollar is "strong" relative to the yen since the dollar's forward value exceeds the spot value by a premium of 0. The yen would trade at a discount because its forward value regarding dollars is less than its spot rate. To calculate the forward discount for the yen, you first need to calculate the forward exchange and spot rates for the yen in the relationship of dollars per yen.
For the calculation of periods other than a year, you would input the number of days as shown in the following example. To calculate the forward rate, multiply the spot rate by the ratio of interest rates and adjust for the time until expiration.
As an example, assume the current U. The domestic interest rate or the U. In this case, it reflects a forward premium. A forward contract is an agreement between two parties to purchase or sell a currency at a definite price on a particular future date.
It is similar to a futures contract with the primary difference being that it trades in the over-the-counter OTC market. Counterparties create the forward contract directly with each other and not through a formalized exchange. Benefits of the forward contract include customization of terms, the amount, price, expiration date , and delivery basis. Delivery may be in cash or the actual delivery of the underlying asset.
Drawbacks over future contracts include the lack of liquidity provided by a secondary market. Another deficiency is that of a centralized clearing house which leads to a higher degree of default risk. As a result, forward contracts are not as readily available to the retail investor as futures contracts. The contracted forward price may be the same as the spot price, but it is usually higher, resulting in a premium.
If the spot price is lower than the forward price , then a forward discount results. Investors or institutions engage in holding forward contracts to hedge or speculate on currency movements. Banks or other financial institutions engaging in investing in forward contracts with their customers eliminate the resulting currency exposure in the interest rate swaps market.
A forward discount occurs when the expected future price of a currency is below the spot price, which indicates a future decline in the currency price. ¥ / $ forward exchange rate is (1÷ = ). · ¥ / $ spot rate is (1÷ = ). · Annualized forward discount for the yen, in terms of dollars. The pre-determined FX rate is determined at deal inception and is referred to as the forward exchange rate. FX forwards are off-balance sheet instruments.