Final answer:
When the forward exchange rate exceeds the spot exchange rate, the foreign currency is trading at a forward premium, indicating an expectation of the currency's strength in the future. This contrasts with a forward discount, where the forward rate is less than the spot rate. Over time, high inflation can lead to currency depreciation, and exchange rates generally adjust towards purchasing power parity.
Step-by-step explanation:
When the forward exchange rate exceeds the spot exchange rate, the foreign currency is said to be trading at a forward premium. This means that investors believe the currency will be stronger in the future compared to the present spot rate - hence they are willing to pay a premium for it in the future. Conversely, if the forward rate is less than the spot rate, the currency is said to be trading at a forward discount. A currency at 'par' would indicate that the forward and spot rates are equal. An 'inflationary discount' is not a standard term in the context of exchange rates.
Examining exchange rate markets further, the demand for a currency, such as the U.S. dollar, increases when there's a higher rate of return, causing a shift in the exchange rate. Similarly, relative inflation can affect the exchange rate; countries with higher inflation rates compared to others often see a decrease in demand for their currency, leading to depreciation.
Countries like Mexico, which experienced significant inflation in 1986-87, saw their currency's exchange rate decline due to decreased demand and increased supply in the foreign exchange markets. The peso's value fell from $2.50 to $0.50 per peso, despite the traded quantity remaining the same. In such situations, exchanges tend to move towards purchasing power parity over the long-term.