How Forward Rate is Determined?

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The determination of forward rate or the relation between spot and forward rates depends upon (a) the interest rates between the money markets of the two countries and (b) the interest arbitrage.

In the absence of anticipated movements of foreign exchange rate, the forward (or future) rate will be the same as the spot rate if rates of interest are the same in the two money markets.

On the other hand, if the interest rates are different in the two money markets, the difference will be reflected by the difference between the forward and the spot rates.

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If the forward rate is different from this calculated rate, then there will be arbitrage operations. Arbitrage means buying and selling of two currencies with a view to earn a profit because of the differences in the exchange rates.

If, for example, the forward pound is sold at a rate higher than $2,388, it would be profitable for banks in New York to put more spot funds in London and sell them forward because they can earn more than 1%.

Similarly, London banks would find it profitable to put their money in New York where they can earn 1% per annum plus a premium on forward dollars of more than 2%. This would be better than 3% interest yield which they would be earning in London itself.

As a result of these interest arbitrage operations, the forward rate will fall and become equal to the spot rate plus or minus the difference in the interest rates of the two money markets.

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