Mastering Forward Exchange Rates | CFA Level I Economics

In this lesson, we’ll dive deep into:

• Understanding spot rates and forward rates
• Determining forward premium and discount
• Exploring the arbitrage relationship between spot rates, forward rates, and interest rates
• Delving into foreign exchange markets and their participants

Understanding Spot Rates and Forward Rates

A spot exchange rate is the currency exchange rate for immediate delivery, which for most currencies means the exchange of currencies takes place two days after the trade. It represents the current market price at which a currency pair can be bought or sold.

On the other hand, a forward exchange rate is the currency exchange rate for a future exchange, which can be 30, 60, 90, 180 days, or one year. Forward exchange rates are determined by the difference in interest rates between the two currencies and the time to maturity of the contract.

Determining Forward Premium and Discount

When the forward rate is higher than the spot rate, there is a forward premium. This indicates that the market expects the base currency to appreciate relative to the quote currency. Conversely, when the forward rate is lower than the spot rate, there is a forward discount. This implies that the market expects the base currency to depreciate relative to the quote currency.

To calculate the forward premium or discount, we use the following formula:

Forward premium/discount (in %) = (Forward Rate – Spot Rate) / Spot Rate × 100

It’s essential to understand the forward premium or discount when evaluating the potential risks and rewards of a forward contract. It can help businesses and investors better anticipate future currency movements and make informed decisions.

Exploring the Arbitrage Relationship Between Spot Rates, Forward Rates, and Interest Rates

The no-arbitrage relationship between the forward rate, spot rate, and interest rates is given by:

Forward Rate = Spot Rate × (1 + Domestic Interest Rate) / (1 + Foreign Interest Rate)

This relationship is derived from the concept of interest rate parity, which assumes that investors will be indifferent between investing in two different currencies if the expected returns are the same when adjusted for exchange rate changes.

Delving into Foreign Exchange Markets and Their Participants

Transactions in the foreign exchange markets can be for hedging or speculation. When a firm takes a position in the foreign exchange market to reduce an existing risk, we say the firm is hedging its risk. Alternatively, when a transaction increases currency risk, we term it as speculation. Investors, companies, and financial institutions, such as banks and investment funds, regularly enter into speculative foreign currency transactions.

There is a diverse range of market participants in the foreign exchange markets, including:

• Corporations: Engage in cross-border transactions and use FX forward contracts to hedge the risk of future receipts and payments in foreign currencies.
• Real money accounts: Mutual funds, pension funds, insurance companies, and other institutional accounts that hedge their currency risk if they hold foreign securities.
• Leveraged accounts: Investment firms that use derivatives, including hedge funds, high-frequency algorithmic traders, and the proprietary trading desks at banks.
• Retail market: Households and relatively small institutions trading for tourism, cross-border investment, or speculative trading.
• Government entities: Governments, central banks, and sovereign wealth funds that engage in FX transactions for various purposes, such as affecting exchange rates, hedging currency risks, or speculating for higher returns.

Understanding the functions and participants in the foreign exchange markets is crucial for grasping the dynamics of currency movements and making informed decisions about currency risk management.

Conclusion

Now you have a better understanding of forward exchange rates, the difference between forward premium and discount, the arbitrage relationship between spot rates, forward rates, and interest rates, as well as the functions and participants in foreign exchange markets. This knowledge will help you better navigate the world of international finance and make informed decisions when dealing with currency risks.