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Essay text:
In this context, the forward premium must be equal to the difference between the forward exchange rate Ft and the spot exchange rate S0 of one currency, divided by this spot exchange rate S0.
The theory of CIRP (assumed without transaction cost) states that the forward premium and the interest rates differential between similar assets of two countries are related as follows in an efficient market over a specified period, i.e. a market where there are no arbitrage opportunities:
F0,t - S0 = i - i* (1)
S0 1+ i*
leading to F0,t = 1+ i
S0 1+ i*
where F0,t , S0, i and i* are respectively the forward exchange rate, the spot exchange rate, the domestic interest rate and the foreign interest rate...
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