Final answer:
The EUR/USD forward rate of 0.85 compared to the spot rate of 0.88 indicates that the EUR is at a forward discount, suggesting that the euro is expected to be weaker against the dollar in six months.
Step-by-step explanation:
To determine whether the EUR is selling at a forward premium or discount, we must compare the spot exchange rate to the forward exchange rate. The spot exchange rate for EUR/USD is given as 0.88, meaning 1 euro can be exchanged for 0.88 US dollars. The six-month (180-day) forward rate for EUR/USD is 0.85, indicating that 1 euro can be exchanged for 0.85 US dollars in the future. A forward premium implies that the forward rate is higher than the spot rate, which would indicate that the currency is expected to appreciate in value.
Conversely, a forward discount means that the forward rate is lower than the spot rate, suggesting that the currency is expected to depreciate. In this case, since the forward rate of 0.85 is less than the spot rate of 0.88, the EUR is selling at a forward discount. This implies that the market expects the euro to be weaker relative to the US dollar in six months. The aforementioned French firm experiencing exchange rate fluctuations is a clear example of how a changing exchange rate can affect international business operations. If this firm sold products in the US for $10 million and converted the money to euros when the exchange rate was $1.06/euro, it would have suffered a loss due to the higher value of the euro. In contrast, a weaker euro relative to the US dollar could potentially improve this firm's profitability, as the cost of production in euros would be lower relative to the revenue earned in US dollars.