Forward Exchange Rate

Forward exchange markets deal in promises to sell or buy foreign exchange at a specified rate, and at a specified time in the future with payment to be made upon delivery. These promises are known as forward exchange and the price is the forward exchange rate. Forward exchange markets do not operate during periods of hyperinflation.

The forward exchange market resembles the futures markets found in organized commodity markets, such as wheat and coffee. The primary function of forward market is to afford protection against the risk of fluctuations in exchange rates. Forward markets are most useful

• under flexible exchange rate system and if there are significant exchange variations,
  
• under fixed exchange rate system, if there is a strong possibility of devaluation/revaluation,

• it cannot function when exchange control is imposed.
  
• it cannot function during perids of hyperinflation.

Interest Parity Theory (Keynes)

When short term interests are higher in one market than in another, investors will be motivated to shift funds between markets, say New York and London. Investors borrow (or buy) a low interest currency and lend the same amount in a high interest currency. This is called carry trade. There is roughly a 5% difference in the interest rates between Japan and the US. To make profits from differeing interest rates, investors must convert, for example, dollars (a low interest currency) into pound sterling (a high interest currency) for investment in London. However, they would be exposed to an exchange risk. If the exchange rate is stable, the investors gain the interest differential, (i - i*), by shifting funds from New York to London.

If pound appreciates during the investment period, the foreign investors will reap additional gain in the change in the exchange rate. However, if pound depreciates, they will experience an exchange loss. The exchange loss may partially or more than offset the gain in the interest income.

To avoid this exchange loss, dollar investors want cover against the exchange loss by selling pound forward. The amount of forward pound to sell is equal to the purchase of spot pound plus the interest earned in London. This practice is called interest arbitrage. Interest arbitrage links the two national money markets and the forward market.

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