explain why currencies of countries with high inflation rates tend to have forward discounts.?

Answer 1

Investors have the choice to invest in their own currency or in another currency. Countries with high inflation have also higher nominal interest rates.

Lets say you live in Inflation land and you have the choice to invest your Inflation $ for 10% per year. If you invest 100,000 you will have a return after 1 year of 110,000.

Now you can also invest in Strong dollars with a rate of 5% and an spot exchange rate of 2 Strong dollars for every Inflation dollar. You can now buy 200,000 Strong dollars and invest them for a year at 5%, giving you 210,000 after one year. For you this is a good investment only if after that year 210,000 Strong dollars are more than the 110,000 Inflation dollars you could have had. So if the exchange rate is 210,000 / 110,000 = 1.9090

Huge international money flows always make sure that there are no significant opportunities to prefer one strategy over the other, which means that on a forward basis, the higher interest rate you can get will translate in a lower forward rate. It is al completely mechanical, no magic involved.

Answer 2

Simply because the domestic price level (hence inflation) is affected primarily by one set of variables, while exchange rates are affected primarily by a different set of variables. Both are ways of assigning value to the same currency, but the two perspectives can diverge because national economies are to some degree insulated from the outside world. This is obvious from the common fact that many products sell for substantially different prices in different countries, even accounting for exchange rates -- and this can be the case for any purchase that's not readily substitutable with an imported product, which is to say most things (lunch, hotel room, taxi ride, haircut, accountant's fees, etc etc). There are enough international trade linkages that inflation and exchanges rates aren't going to be totally out of whack for an extended period of time, but on the other hand there is enough domestic economy insulation and friction and barriers to trade that the phenomenon can frequently diverge.

Answer 3

As far as i know currencies with high interest rate sells at discount at the forward market
and currencies with low interest rate sells at premium.

The reason is: To balance everthing and avoid arbitrage profits
Example US and JPY

JPY has 0.25 rates and US has 5.25 percent X-rate is 121

Borrow 100,000 USD in (12.1 Mil yen)JPY Equivalent and pay 0.25 percent annually.

Invest in the US Bills and earn 5.25 percent.
The One year forward will be 115.23

formula is 121/(1+(.0525-.0025))=115.23
If its significantly higher/lower than that arbitrage would occur.

Interest rates:

USD - 5.25 percent
Eurozone 3.5 percent
Switzerland 2 percent
Australia 6.25 percent
Canada 4.25

USD/CAD forwards trade at discount at the forward market.
CAD/CHF forwards trade at a discount at the forward market.
CHF/AUD forwards trade at a premium at the forward market.
Rule: Currencies with high interest relative to other currency sells at a discount. Currencies with low interest rate relative to other currencies sells at a premium.

Answer 4

Based on binary distribution of computational statistics in monetary delivery systems.

Greatly over rated.