Question

if a trader in one country has to pay a premium for forward cover does the trader in the other country have to pay a premium or do they get a subsidy or neither. I think the question means that Trader A is from country A trying to purchase currency B and pays a premium, so would trader B From country B have to pay a premium or receive subsidy or nothing to purchase currency A?? So far i know that bc A has to pay a premium, it indicated that currency B is at a higher interest rate, and that is is over valued

Answer 1

Solution:-

When there are different interest rates in two countries, then exchange rates of their currencies do adjust against each other with time to bring interest rate parity and do away with any possibilities of arbitrage of mispricing.

Now lets say if a trader wants to buy a one year forward contract for foreign currency of a country which has higher interest rates than the home country, it means the value of that foreign currency will decline in 12 months due to differential interest rates. In such a scenario, the forward rates of the currency pair would adjust for the same and the forward rates that the traders would get for the said currency pair would be adjusted for the interest differentials and changes in currency valuations.

Lets take an example to understand this:

Let's say that the current exchange rate of USD-GBP is $1.5/GBP, and the interest rates in the US are 5% where as interest rates in the UK are 2%. Therefore, the forward rates for 12 months contracts would be as follows:

Forward rates= $1.5*(1+5%)= GBP1*(1+2%)= $1.544 per GBP

As we can see that USD is getting depreciated against GBP because interest rates in the US are higher than the UK

Therefore, if a UK trader enters into a forward contract to sell USD in 12 month's time, he will have to pay a premium and will get one GBP against $1.544. On the contrary, the other side of the contract, i.e. the US trader would get a discount compared to the current rates as he will be able to buy $1.544 against one GBP.

Therefore, as we can see one trader gets a discount by buying more amount of dollar against GBP (as compared to current rates) and the other trader pays a premium by paying more dollars to buy GBP (as compared to current rates).