How does forward exchange rate
- How does forward exchange rate differ from spot exchangerate?
- Suppose £ represents British pound and ¥ represents Japaneseyen. If E¥/£ = 150 in Tokyo while E¥/£ = 155in London. How would you do arbitrage to make a profit?
- What is the meaning of covered interest parity? How do you useit to determine the forward exchange rate?
- What is the meaning of uncovered interest parity? How do youuse it to determine the spot exchange rate?
Answer:
Difference in forward andspot exchange rate :
- Meaning – SPOT as word suggests tells aboutthe present exchange rate i.e. what rate one will get for currencyhowever FORWARD also as it suggests it tells about the future rateof exchange for the currency
- Dealing transactions – SPOT deals with thecurrent transaction in foreign market however FORWARD deals withtransactions which are contracted in present but will beimplemented in future
- QUOTATIONS – SPOT are given neither premiumnor discount however the FORWARD are given in premium ordiscount
- Reason for offers – SPOT shows the presentmarket condition which cannot be altered as such so no need fordiscounts or premium however FORWARD gives such offer to make itattractive as there can be loss or profit due to change inrate
- Nature – SPOT works on daily nature or currentmarket however FORWARD works on future market
MAKE ARBITRAGEPROFIT:
First, arbitrage profit is when a person can take advantage ofdifference in the market price in different economies as a resultbuying from cheap economy and selling it in high priced economyhelps to gain profit
Example as in TOKOYO the price of currency is 150 and in LONDONit’s 155 , so buying from TOKOYO and selling in London would makethe investor profit of 5 on each unit.
COVERED INTEREST PARITY ANDUSE IN FORWARD EXCHANGE RATE :
Meaning – The covered interest parity or CIP isa general principle in financial market so that ” the difference ofinterest of two currency in there money market should EQUATE withthe difference in the forward and spot exchange rate
Role in forward exchange rate – -It can behelpful to determine the forward exchange market owing to its NOARBITRAGE CONDITION because of which a person can defend himselffrom the future uncertainities and risk . However parity can occurat a time and can change over time
UNCOVERED INTEREST PARITYAND SPOT EXCHANGE RATE :
Meaning – Unlike covered it basically helps toforecast rates and not insuring with the risk; it is the differencein the rate of interest of two nations at the time when it equatesthe relative change in foreign exchange rate
Role in spot exchange rate – as it does onlyforecasting so with it one cannot determine any future rate ofcontracts ,so we use expected spot rate only from which isprevailing in market. However to get spot rate one should thatdiscount rate with which one can make the present value of assetequal to its price quoted
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