Chartered Financial Analyst (CFA) Practice Exam Level 2

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Which equation represents the forward premium or discount?

F = S * Id/If
=(S - F) / F
=(F - S) / S
F = S + Interest Rate Differential

The correct answer is: =(F - S) / S

The correct answer is represented by the equation that calculates the forward premium or discount as a function of the spot and forward exchange rates. This is done by taking the difference between the forward rate and the spot rate, then dividing that by the spot rate. This ratio provides a percentage, which indicates whether the currency is trading at a premium or discount in the forward market relative to the spot market. When the result is positive, it indicates a forward premium, suggesting that the forward rate is higher than the spot rate, which often occurs if the interest rates of the currency being bought are higher than those of the currency being sold. Conversely, a negative result indicates a discount, meaning the forward rate is lower than the spot rate, usually reflecting lower interest rates for the first currency in comparison to the second. The other options do not correctly represent the calculation of forward premium or discount. For example, simply using the interest rate differential does not account for the relationship with the spot rate, while other formulations may lead to ratios that do not accurately reflect the percentage change needed to understand premium and discount dynamics in foreign exchange markets.