Forward Premium Implications

CFA Level I
#1

Hey guys,

I am having trouble with this question:

_ A forward premium indicates: _

a) an expected increase in demand for the base corrency

b) the interest rate is higher in the base currency than in hte price currency.

c) the interest is higher in the price currency than in the base currency.

Answer:

c) is correct. To eliminate arbitrage opportunities, the following has to hold:

F/S=(1+i_p)/(1+i_b)

I do understand why c) is correct, but wouldn’t a) also be correct? Since the equations imply that the base currency will become more valued in the future. Or has this something to do with the way forwards are priced through arbitrage and not through predictions of the future?

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#2

The forward price is not the same as the expected spot price.

As you say: forward prices are set by interest rate parity.

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#3

I see, that makes sense. Thanks S2000!!

It is really interesting how all the individual topics from the various parts of the cfa exam are all intertwined in so many ways, for instance how this relates to chapter on derivates (pricing of forwards etc.).

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