According to the forward expectation's theory of exchange rates, the current spot futures rate will be the future spot rate. This theory is rooted in empirical studies and is a reasonable assumption over a long-term time horizon. Typically, a forward premium reflects possible changes arising from differences in the interest rate between the two currencies of the two countries involved.
Forward currency exchange rates are often different from the spot exchange rate for the currency. If the forward exchange rate for a currency is more than the spot rate, a premium exists for that currency. A discount happens when the forward exchange rate is less than the spot rate. The basics of calculating a forward rate require both the current spot price of the currency pair and the interest rates in the two countries see below.
Consider this example of an exchange between the Japanese yen and the U. In this case, the dollar is "strong" relative to the yen since the dollar's forward value exceeds the spot value by a premium of 0.
The yen would trade at a discount because its forward value regarding dollars is less than its spot rate. To calculate the forward discount for the yen, you first need to calculate the forward exchange and spot rates for the yen in the relationship of dollars per yen. For the calculation of periods other than a year, you would input the number of days as shown in the following example. To calculate the forward rate, multiply the spot rate by the ratio of interest rates and adjust for the time until expiration.
As an example, assume the current U. The domestic interest rate, or the U. In this case, it reflects a forward premium. Advanced Forex Trading Concepts. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. You are welcome to learn a range of topics from accounting, economics, finance and more.
We hope you like the work that has been done, and if you have any suggestions, your feedback is highly valuable. Let's connect! Definition Formula Example. All Chapters in Finance. Current Chapter. It will come with a couple of exchange rates, interest rates and dates, and there would be one thing missing that you will be required to calculate.
This brief write up attempts to provide an intuitive understanding of how and why covered interest parity works. There are a number of questions relating to this that I have included in the question pool, and this article addresses the key concepts with some examples. What covered interest parity says is that our investor would be equally well off in both the circumstances. If this were not to be true, and investing in dollars and converting back to francs later did indeed offer an advantage over investing in CHF, arbitrageurs would immediately borrow a large number of Swiss Francs, and convert them for investing in US Dollars while at the same time covering their future risk by entering into forward contracts.
This would push the forward exchange rate in a way that there would be no money to be made from this trade. Therefore, the forward exchange rate is just a function of the relative interest rates of two currencies.
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