Economics
Forward Rates
Forward rates are the future exchange rates agreed upon today for a currency pair. They represent the expected future spot rate at a specified time. Forward rates are used by businesses and investors to hedge against currency risk and to lock in future exchange rates for budgeting and planning purposes.
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11 Key excerpts on "Forward Rates"
eBook - PDF- Alan C. Shapiro, Peter Moles(Authors)
- 2014(Publication Date)
- Wiley(Publisher)
This means that currency forecasts can be obtained by extracting the predictions already embodied in interest and Forward Rates. Forward Rates. Market-based forecasts of exchange rate changes can be derived most simply from current Forward Rates. Specifically, f 1 —the forward rate for one period from now—will usually suffice for an unbiased estimate of the spot rate as of that date. In other words, f 1 should equal e 1 , where e 1 is the expected future spot rate. Interest Rates. Although Forward Rates provide simple and easy-to-use currency forecasts, their forecasting horizon is limited to about one year because of the general absence of longer-term forward contracts. Interest rate differentials can be used to supply exchange rate predictions beyond one year. For example, suppose five-year interest rates on U.S. dollars and euros are 6% and 5%, respectively. If the current spot rate for the euro is $0.90 and the (unknown) value of the euro in five years is e 5 , then $1.00 invested today in euros will be worth (1.05) 5 e 5 ∕0.90 U.S. dollars at the end of five years; 21 These criteria were suggested by Giddy and Dufey, “The Random Behavior of Flexible Exchange Rates”.
eBook - PDFForeign Exchange in Practice
The New Environment
- S. Anthony(Author)
- 2002(Publication Date)
- Palgrave Macmillan(Publisher)
CHAPTER 6 Forward Exchange Rates In this chapter the concept of forward exchange rates is developed. The forward exchange rate can be calculated from the spot rate and the interest rates of two currencies. The concept is extended to cover short dates and long-term foreign exchange. If the one year dollar interest rate is 5% p.a., $100 has a future value of $105 one year from now. It follows that if the spot price of gold is $300, the one year forward price of gold is $315. Gold could be said to command a forward premium of $15 (or 5%) as the forward price is $15 (or 5%) higher than the spot price. Forward exchange rates are determined in the same way as the forward gold price, except that as exchange rates involve two currencies, there are two interest rates involved. 1 Definition A forward exchange rate is a rate agreed today at which one currency is sold against another for delivery on a specified future date. For example, on 2 September, US$1,000,000 is sold against ¥118,510,000 for value 4 March at a forward rate US$1 = ¥118.51. The rate is agreed on 2 September. The currencies are exchanged 6 months later on 4 March. CALCULATION OF FORWARD EXCHANGE RATES Forward Rates differ from spot rates to reflect the differing interest rates prevailing in the two currencies. 78 1 In reality gold interest rates are not equal to zero, so the forward gold price is a function of the gold interest rate as well as spot gold and the dollar interest rate. EXAMPLE 6.1 If the spot rate is US$1 = ¥120 and 6 months dollar and yen interest rates are 3.00% p.a. and 0.50% p.a. respectively, calculate the 6 month forward exchange rate. By the end of the 6 month period: US$1,000,000 would be worth 1,000,000 × (1 + 0.03 × 6/12) = $1,015,000 ¥120,000,000 would be worth 120,000,000 × (1 + 0.005 × 6/12) = ¥120,300,000 The 6 month forward exchange rate would be such that: US$1,015,000 US$1 = = ¥ , , ¥ , , , , 120 300 000 120 300 000 1 015 00 0 118 52 = ¥ .
eBook - PDF- Dominick Salvatore(Author)
- 2014(Publication Date)
- Wiley(Publisher)
4. From the exchange rate between each of a pair of currencies with respect to the dollar, the cross rate between the two currencies themselves can be determined. The effective exchange rate is a weighted average of Chapter Eleven The Foreign Exchange Market and Exchange Rates 293 the exchange rates between the domestic currency and the nation’s most important trade partners. Arbitrage refers to the purchase of a currency where it is cheaper for immediate resale where it is more expensive. This equalizes exchange rates and ensures consistent cross rates in all monetary centers. 5. If the quantity demanded of euros on U.S. private transactions exceeds the quantity supplied, the dollar would depreciate until the excess demand for euros is eliminated. To keep the exchange rate fixed, the U.S. monetary authorities would have to satisfy the excess demand for euros out of their official euro reserves (a U.S. balance of payments deficit). A potential U.S. balance of payments deficit could also be covered partly by a dollar depreciation and partly by the loss of U.S. official reserves. 6. A spot transaction involves the exchange of currencies for delivery within two business days. A forward transaction is an agreement to purchase a specified amount of a foreign currency for delivery at a future date (usually one, three, or six months hence) at a rate agreed upon today (the forward rate). When the forward rate is lower than the spot rate, the foreign currency is said to be at a forward discount of a certain percentage per year. In the opposite case, the foreign currency is said to be at a forward premium. 7. A foreign exchange futures is a forward contract for standardized currency amounts, available for specific currencies and selected calendar dates and traded on an organized exchange. A foreign exchange option is a contract specifying the right to buy or sell a standard amount of a traded currency at or before a stated date.
eBook - PDF- Shani Shamah(Author)
- 2003(Publication Date)
- Wiley(Publisher)
The details are presented in Figure 8.2. 8.7 USES OF FORWARDS Forward contracts are a common hedging product and are used by importers, exporters, in- vestors and borrowers. They are valuable to those with existing assets or liabilities in foreign currencies and to those wanting to lock in a specific future foreign exchange rate. For example, corporations that must receive or pay foreign currencies in the future because of their normal business activities usually prefer to transfer the risk that the values of these currencies may change during the intervening period. They can use the bank forward market to establish to- day, the exchange rate between two currencies for a value date in the future. Generally, when Par 2 Points descending: DEDUCT 1 earn points earn points + −20 −15 +20 Points ascending: ADD 3 + − − pay points pay points Market maker quote: sell dollars Market maker quote: buy dollars +15 1 Deduct: The dollar is at a discount when it is more expensive on an interest basis than the currency. These dollar discounts/currency premiums are always deducted from the spot rate. 2 Par: Interest rates for both dollar and currency are equal. 3 Add: The dollar is at a premium to the currency when it is cheaper on an interest basis than the currency. These dollar premiums/currency discounts are always added to the spot rate. Figure 8.3 Example of forward transactions 54 A Foreign Exchange Primer corporations contract to pay to or receive from a bank foreign currency in the future, no money is exchanged until the settlement on the value date. While forwards may be used to hedge payables and receivables, corporations will also hedge other assets and liabilities on a company’s balance sheet. The value dates of forward contracts are often constructed to match up with the expected dates of receipts for a foreign payment, or payment of a foreign currency obligation. A forward contract can be tailored to meet a client’s specific needs in terms of delivery dates and amount.
eBook - ePubForeign Exchange
A Practical Guide to the FX Markets
- Tim Weithers(Author)
- 2011(Publication Date)
- Wiley(Publisher)
CHAPTER 6Foreign Exchange ForwardsMoney often costs too much.—Ralph Waldo EmersonINTRODUCTION TO FORWARDS AND FORWARD PRICING
In some ways, the financial markets involve transactions that are similar to more mundane experiences. While on a trip, I may need a place to sleep. I could simply attempt to locate lodgings as my bedtime approaches, but that could prove problematic. I may not be able to find a vacancy, but, even if I could, I would have no idea what I would have to pay (and would probably feel like I was being taken advantage of, upon hearing that there are vacancies, but that I would have to pay $400 for that evening’s stay). In short, many of us who travel tend to arrange for our hotel/motel accommodations in advance. That way, we are ensured that we can get what we would like—at a price that we feel is reasonable. A large number of foreign exchange trades are done in this fashion. If you arrange a currency trade, locking in a price (an exchange rate) and a quantity in advance, this is known as a “forward contract,” a “forward transaction,” a “forward trade,” or, simply, a “forward.”There is no reason why you should expect the price in a forward trade to be the same as the price in a spot transaction. Would you expect the price of bananas to be the same in Helsinki as in Honduras? No. These prices would differ because the trades would occur at different points on the globe. An FX forward trade will generally involve a different price than a spot trade; these transactions take place at different points as well—different points in time (and, as you may have heard, time is money)!Let me start this section by asking you a question or two (and, to try to make the point, let’s get away from FX for the moment). Could I ever convince you to voluntarily agree to buy a stock today for S = USD 50 (a spot transaction) and simultaneously get you to agree to sell that stock in a week (a one-week forward transaction) for F = USD 48? Stop and think about it. It doesn’t sound good, does it?
- Jae K. Shim, Michael Constas(Authors)
- 2001(Publication Date)
- CRC Press(Publisher)
It merely means that the forward rate will, on Maturity Bid Offer Spot .2186 .2189 1-month .2188 .2192 3-month .2180 .2184 6-month .2175 .2179 FORWARD RATE QUOTATIONS 129 average, under- and over-estimate the actual future spot rates in equal frequency and degree. As a matter of fact, the forward rate may never actually equal the future spot rate. The relationship between these two rates can be restated as follows: The forward differential (premium or discount) equals the expected change in the spot exchange rate. Algebraically, With indirect quotes: With direct quotes: The relationship between the forward rate and the future spot rate is illustrated in Exhibit 59. See also APPRECIATION OF THE DOLLAR; PARITY CONDITIONS. EXHIBIT 59 Relationship Between the Forward Rate and the Future Spot Rate Difference between forward and spot rate F S – S ------------equals Expected change in spot rate S 2 S 1 – S 1 ---------------Spot forward – Spot -----------------------------------Beginning rate ending rate – Ending rate -------------------------------------------------------------------= Forward Spot – Forward ------------------------------------Ending rate beginning rate – Beginning rate -------------------------------------------------------------------= Parity line 5 4 3 2 1 1 2 3 4 5 -1 I J -1 -2 -3 -4 -5 -2 -3 -4 -5 Expected change in home currency value of foreign currency (%) Forward premium (+) or discount (-) on foreign currency (%) Forward Rates AS UNBIASED PREDICTORS OF FUTURE SPOT RATES 130 FORWARD TRANSACTION Forward transactions are types of transactions that take place in the forward foreign exchange market ( forward market ). In the forward market, unlike in the spot market where currencies are traded for immediate delivery, trades are made for future dates, usually less than one year away. The forward market and the futures market perform similar functions, but with a difference.
eBook - ePubEconomics for Investment Decision Makers
Micro, Macro, and International Economics
- Christopher D. Piros, Jerald E. Pinto(Authors)
- 2013(Publication Date)
- Wiley(Publisher)
Expected versus unexpected changes. In reasonably efficient markets, prices will adjust to reflect market participants’ expectations of future developments. When a key factor, say inflation, is trending gradually in a particular direction, market pricing will eventually come to reflect expectations that this trend will continue. In contrast, large, unexpected movements in a variable (for example, a central bank intervening in the foreign exchange market) can lead to immediate, discrete price adjustments. This concept of expected versus unexpected changes is closely related to what might broadly be referred to as risk. For example, a moderate but steady rate of inflation will not have the same effect on market participants as an inflation rate that is very unpredictable. The latter clearly describes a riskier financial environment. Market pricing will reflect risk premiums—that is, the compensation that traders and investors demand for being exposed to unpredictable outcomes. Whereas expectations of long-run equilibrium values tend to evolve slowly, risk premiums—which are closely related to confidence and reputation—can change quickly in response to unexpected developments.4. Relative movements. An exchange rate represents the relative price of one currency in terms of another. Hence, for exchange rate determination, the levels or variability of key factors in any particular country are typically much less important than the differences in these factors across countries. For example, knowing that inflation is increasing in Country A may not give much insight into the direction of the A/B exchange rate without also knowing what is happening with the inflation rate in Country B.As a final word of caution—and this cannot be emphasized enough: There is no simple formula, model, or approach that will allow market participants to precisely forecast exchange rates
No longer available |Learn more- (Author)
- 2019(Publication Date)
- Wiley(Publisher)
Foreign Exchange Market Concepts We begin with a brief review of some of the basic conventions of the FX market that were covered in the CFA Level I curriculum. In this section, we cover (1) the basics of exchange rate notation and pricing, (2) arbitrage pricing constraints on spot rate foreign exchange quotes, and (3) Forward Rates and covered interest rate parity. An exchange rate is the price of the base currency expressed in terms of the price currency. For example, a USD/EUR rate of 1.3650 means the euro, the base currency, costs 1.3650 US dollars (an appendix defines the three-letter currency codes used in this reading). The exact notation used to represent exchange rates can vary widely between sources, and occasionally the same exchange rate notation will be used by different sources to mean completely different things. The reader should be aware that the notation used here may not be the same as that encountered elsewhere. To avoid confusion, this reading will identify exchange rates using the convention of “P/B,” referring to the price of the base currency “B” expressed in terms of the price currency “P.” 1 The spot exchange rate is usually used for settlement on the second business day after the trade date, referred to as T + 2 settlement. 2 In foreign exchange markets—as in other financial markets—market participants are presented with a two-sided price in the form of a bid price and an offer price (also called an ask price) quoted by potential counterparties. The bid price is the price, defined in terms of the price currency, at which the counterparty is willing to buy one unit of the base currency
eBook - PDF- Debra C. Jeter, Paul K. Chaney(Authors)
- 2019(Publication Date)
- Wiley(Publisher)
The change in the time value of the forward contract = the change in the premium multiplied by the foreign currency. Foreign Currency Transactions 445 There are a number of business situations in which a firm may desire to acquire a forward exchange contract. The uses of forward contracts include the following: 1. Hedges a. Forward contracts used as a hedge of a foreign currency transaction. These include importing and exporting transactions denominated in foreign currency. These hedges do not qualify for hedge accounting because the foreign exchange gains and losses are already reported in earnings under FASB ASC paragraph 830‑10‑15‑3, and the payables and receivables are reported at market value on the balance sheet. b. Forward contracts used as a hedge of an unrecognized firm commitment (a fair value hedge). An example of an unrecognized firm commitment is when a firm enters into a contract to purchase an asset in two months for a fixed amount of foreign currency. Since the exchange rate may change over the next two months, the firm might use a forward contract to hedge the potential change in value of the purchased asset. Hedge accounting rules apply. Both the change in value of the hedge and the value of the hedged item are reported in earnings (before the contract is reported on the books). This is illustrated later. c. Forward contract used as a hedge of a foreign-currency-denominated “fore- casted” transaction (a cash flow hedge). A forecasted transaction is a situation where the firm has planned sales receipts (expected to occur in the near future) and uses the forward contract as a means to hedge the cash flow risk. Initially, Why Do Forward Rates Differ from Spot Rates? Forward Rates for the purchase or sale of foreign currency, on some future date, can be higher, lower, or equal to the current spot rate on that currency.
eBook - PDFArbitrage, Hedging, and Speculation
The Foreign Exchange Market
- Ephraim Clark, Dilip K. Ghosh(Authors)
- 2004(Publication Date)
- Praeger(Publisher)
He is faced with the fol- lowing situation: The dollar is at a premium. At the current spot exchange rate, the importer's cost in won would be 13.13 billion won. At the forward exchange rate, it would be 13.29 billion won, considerably higher than the 13.13 billion at the current spot rate. Buying forward effectively eliminates the exchange risk but at a price higher than the current exchange rate. Thus, if the Korean importer hedges, the price he charges his customers should be calculated on the forward rate and not the current spot rate. If he does not hedge he, of course, would not know what his cost is until he actually pays for the merchandise. Hedging Positions Longer than One Year Hedging positions longer than one year can be derived directly from equation 2.2, reproduced here: where rand r*represent the continuous time interest rates on zero coupon domestic and foreign loans, respectively. EXAMPLE: Consider a bank contemplating a two-year forward contract to buy Swiss francs. The relevant information is given as follows: 9 T = Two years The spot USD/CHF exchange rate S 0 (USD/CHF) = 0.6005 - 0.6015 r = Continuous time interest rate on two-year zero coupon dollar loans = 4 ! /2 — 4 3 A r* = Continuous time interest rate on two-year zero coupon franc loans = 9 3 A - 10. Currency Futures, Swaps, and Hedging 39 According to equation 2.2, the bank could hedge a two-year forward con- tract to buy francs by borrowing francs for two years, selling the francs spot for dollars and lending the dollars for two years. The forward rate that the bank would have to charge its customer would be somewhere below: In practice there are not many zero coupon loans available. Conse- quently, an exact hedge calculation must take into consideration the cash flows resulting from interest payments at the end of the year. Rolling Over and Closing Out Forward Contracts As we mentioned above, expected inflows or outflows of foreign cur- rency are not always realized.
- Philip L Paarlberg(Author)
- 2019(Publication Date)
- CRC Press(Publisher)
PART I EXCHANGE RATES: SOME VIEWS FROM INTERNATIONAL FINANCE 2 Explaining the Demand for Dollars: International Rates of Return, and the Expectations of Chartists and Fundamentalists Jeffrey A. Frankel and Kenneth A. Froot The careening path of the dollar in recent years has shattered more than historical records and the financial health of some speculators. It has also helped to shatter faith in economists' models of the determination of exchange rates. We have understood for some time that under conditions of high international capital mobility, currency values will move sharply and unexpectedly in response to new information. Even so, actual movements of exchange rates have been puzzling in two major respects. First, the proportion of exchange-rate changes that we are able to predict seems to be, not just low, but zero. According to rational expectations theory we should be able to use our models to predict that proportion of exchange rate changes that are correctly predicted by exchange market participants. Yet neither models based on economic fundamentals, nor simple time series models, nor the forecasts of market participants as reflected in the forward discount or in survey data, seem able to predict better than the lagged spot rate. Second, the proportion of exchange rate movements that can be explained even after the fact, using contemporaneous macroeconomic variables, is disturbingly low. Jeffrey A. Frankel, Department of Economics, University of California-Berkeley, Berkeley, CA. and Kenneth A. Froot, Sloan School of Management, Massachusetts Institute of Technology--Cambridge, MA. 25 26 FUNDAMENTALS, BUBBLES, AND TESTS OF RATIONAL EXPECfATIONS Most of the models of exchange rate determination that were developed after 1973 are driven by countries' supplies of assets: supplies of money alone in the case of the monetary models, and supplies of bonds and other assets as well in the case of the portfolio-balance models.
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