27 Interpreting changes in the forward premium.

Assume that interest rate parity holds. At the beginning of the month, the spot rate of the Canadian dollar is £0.35, while the one-year forward rate is

£0.34. Assume that UK interest rates increase steadily over the month. At the end of the month, the one-year forward rate is higher (foreign currency costs more)

than it was at the beginning of the month. Yet, the one-year forward discount is larger (the one-year premium is more negative) at the end of the month than it was at the beginning of the month. Explain how the relationship between the UK interest rate and the Canadian interest rate changed from the beginning of the month until the end of the month.