Help with Forward Contracts Question

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  • #3305936
    zestyzain
    Participant

    Given a spot exchange rate for the U.S. dollar against the pound sterling of $1.4925 per pound and a 90-day forward rate of $1.4775 per pound,

    The dollar is at a discount against the pound and undervalued in the forward market.
    The forward dollar is at a premium against the pound.
    The dollar is at a premium against the pound and overvalued in the forward market.
    The forward dollar is at a discount against the pound.

    The correct answer is B

    .The spot rate for the pound sterling is 1.4925 U.S. dollars, and the forward rate for the pound sterling is 1.4775 U.S. dollars. The exchange rate for the pound sterling relative to the U.S. dollar is lower in the forward market than the spot market. Conversely, the exchange rate for the U.S. dollar is higher in the forward market than the spot market. Thus, the U.S. dollar is trading at a forward premium in relation to the pound sterling.

    My confusion is I thought that when:

    forward exchange rate > spot rate, premium exists for the currency,

    forward exchange rate < spot rate, discount exists for the currency.

    Am I reading this wrong? Could someone please help explain this to me!!!

    Zain
    #3305939
    thelatebloomer
    Participant

    When the forward rate is less than the spot rate, you have to spend less in exchange for the other, representing a premium. It basically just means it's worth more in the future. Spend less = worth more = premium. Spend more = worth less = discount. And the key with currency value is that it's always relative to other currencies or itself in the future or past.

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    #3305942
    zestyzain
    Participant

    Your explanation made everything make sense! TYSM!

    Zain
    #3305945
    thelatebloomer
    Participant

    No problemo

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