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To understand the differences and relationship between spot rates and forward rates, it helps to think of interest rates as the prices of financial transactions. Consider a $1, bond with an. The forward rate for the currency, also called the forward exchange rate or forward price, represents a specified rate at which a commercial bank agrees with an investor to exchange one given currency for another currency at some future date, such as a one year forward rate.
It is called a forward-forward interest rate because it is for a time period that both begins and ends in the future. Hence, a forward-forward contract protects against market changes in the interest rates.
A forward-forward is different from other interest-rate derivatives. Both forward rate agreements and short-term interest rate futures can protect against market changes in the interest-rate, but they do so by paying the difference between the contract rate and the reference market rate, such as the libor. There are also forward-forward currency swaps, involving the swapping of 1 currency for another at the beginning of the forward period, which is then reversed at maturity. Forward-forwards have a special notation to designate the future term.
In theory, a forward rate formula would equal the spot rate plus any money, such as dividends, earned by the security in question less any finance charges or other charges. The forward and spot rates have the same relationship with each other as a discounted present value and future value have if you were calculating something like a retirement account, wanting to know how much it would be worth in 10 years if you put a certain amount of dollars into it today at a specified interest rate.
Forward exchange contracts are agreements where a company agrees to purchase a fixed amount of foreign currency on a future specified date.
The company makes the purchase at an exchange rate that has been predetermined. The company, by entering into the contract, protects itself from future fluctuations in the exchange rate for the foreign currency. This allows the business to protect itself against losses on foreign currency fluctuations. Additionally, companies may buy forwards to speculate on exchange rate fluctuations to generate gains for themselves. The foreign currency exchange rate consists of the following components: The country that has a lower interest rate trades with a premium, while the higher interest rate company trades with a discount.
When in equilibrium, and when interest rates vary across two countries, the parity condition implies that the forward rate includes a premium or discount reflecting the interest rate differential. Forward exchange rates have important theoretical implications for forecasting future spot exchange rates.
Financial economists have put forth a hypothesis that the forward rate accurately predicts the future spot rate, for which empirical evidence is mixed. The forward exchange rate is the rate at which a commercial bank is willing to commit to exchange one currency for another at some specified future date. It is the exchange rate negotiated today between a bank and a client upon entering into a forward contract agreeing to buy or sell some amount of foreign currency in the future.
Hedging with forward contracts is typically used for larger transactions, while futures contracts are used for smaller transactions. This is due to the customization afforded to banks by forward contracts traded over-the-counter , versus the standardization of futures contracts which are traded on an exchange.
Covered interest rate parity is a no-arbitrage condition in foreign exchange markets which depends on the availability of the forward market. It can be rearranged to give the forward exchange rate as a function of the other variables.
The forward exchange rate depends on three known variables: This effectively means that the forward rate is the price of a forward contract, which derives its value from the pricing of spot contracts and the addition of information on available interest rates. The following equation represents covered interest rate parity, a condition under which investors eliminate exposure to foreign exchange risk unanticipated changes in exchange rates with the use of a forward contract — the exchange rate risk is effectively covered.
Under this condition, a domestic investor would earn equal returns from investing in domestic assets or converting currency at the spot exchange rate, investing in foreign currency assets in a country with a different interest rate, and exchanging the foreign currency for domestic currency at the negotiated forward exchange rate.
Investors will be indifferent to the interest rates on deposits in these countries due to the equilibrium resulting from the forward exchange rate. If these two returns weren't equalized by the use of a forward contract, there would be a potential arbitrage opportunity in which, for example, an investor could borrow currency in the country with the lower interest rate, convert to the foreign currency at today's spot exchange rate, and invest in the foreign country with the higher interest rate.
The equilibrium that results from the relationship between forward and spot exchange rates within the context of covered interest rate parity is responsible for eliminating or correcting for market inefficiencies that would create potential for arbitrage profits. As such, arbitrage opportunities are fleeting.
In order for this equilibrium to hold under differences in interest rates between two countries, the forward exchange rate must generally differ from the spot exchange rate, such that a no-arbitrage condition is sustained. Therefore, the forward rate is said to contain a premium or discount, reflecting the interest rate differential between two countries.
The following equations demonstrate how the forward premium or discount is calculated. In practice, forward premiums and discounts are quoted as annualized percentage deviations from the spot exchange rate, in which case it is necessary to account for the number of days to delivery as in the following example.
For example, to calculate the 6-month forward premium or discount for the euro versus the dollar deliverable in 30 days, given a spot rate quote of 1. Conversely, if one were to work this example in euro terms rather than dollar terms, the perspective would be reversed and one would say that the dollar is trading at a discount against the Euro.
The unbiasedness hypothesis states that given conditions of rational expectations and risk neutrality , the forward exchange rate is an unbiased predictor of the future spot exchange rate. Without introducing a foreign exchange risk premium due to the assumption of risk neutrality , the following equation illustrates the unbiasedness hypothesis.
The empirical rejection of the unbiasedness hypothesis is a well-recognized puzzle among finance researchers. Empirical evidence for cointegration between the forward rate and the future spot rate is mixed.
Here, both parties are required to match the date that the currency is anticipated to be received. The move enables the parties that are involved in the transaction to better their future and budget for their financial projects.
Evidence from a New Test".