I’m just trying to understand the formula better, but how come the Spot is discounted by the foreign Rf and the Forward is discounted by the domestic Rf?
The derivation of that formula is a little complicated, especially here where we don’t have a nice equation editor.
The short answer is that two things are happening:
- You’re discounting the forward exchange rate to time t using interest rate parity.
- If the contract were settled today, you wouldn’t receive the contractual amount of the foreign currency, but the present value of the contractual amount of the foreign currency, discounted at the foreign risk-free rate.
Remember that the formula (spot discounted at foreign – forward discounted at domestic) assumes that the exchange rates are quoted as (dc/fc).