Final answer:
A forward premium suggests higher interest rates in the base currency compared to the price currency, indicating expected currency appreciation. This expectation can increase the demand for the currency, consequently influencing yields on assets like government bonds. Higher expected returns on investments can attract foreign funds, reinforcing the demand for the appreciating currency and impacting yields.
Step-by-step explanation:
A forward premium indicates that the interest rate is higher in the base currency than in the price currency. This situation suggests that the base currency is expected to appreciate over the forward contract period. Investors or companies entering into this kind of contract expect to pay more for the base currency in the future relative to the price currency.
When a country's currency is predicted to increase in value, or appreciate, the effects on the foreign exchange market can result in altered demand and supply. For instance, if the Mexican peso is expected to appreciate, this would likely increase demand for pesos while decreasing the supply, because investors would be more willing to hold onto the currency in anticipation of its growth in value. This change in demand and supply can consequently affect the yields on financial assets, like government bonds. Higher demand for a currency often correlates with higher yields, as investments in that country become more attractive due to the anticipated currency appreciation.
Furthermore, fluctuations in expected exchange rates influence investment motivations globally. If a country offers higher interest rates compared to others, it tends to attract foreign funds because of the higher potential returns. As such, expected appreciation in currency value could lead to a rise in interest rates, securing the country's position as a lucrative investment opportunity, increasing demand for the currency, and in turn, influencing yields positively.