The forward exchange rate is based solely on interest rate differentials and does not take into account investors` expectations of where the real exchange rate might be in the future. Suppose a Canadian company buys $100,000 worth of computer hardware in Japan and has 90 days to pay. When agreeing on the sale price, the exchange rate from yen to dollar is, say, 360 yen equals one Canadian dollar. There is no guarantee that the Canadian dollar will be worth 360 yen when you pay in ninety days. Suppose the exchange rate is 350 yen to the dollar. Then, the Canadian dollars received will only bring in 35 million yen and not the expected 36 million yen— a loss of just under 3% for the Japanese company. If the Canadian export company had agreed to pay 36 million yen instead of $100,000, it would have had to pay $102,857 and lost nearly 3% in the transaction. However, even then, hedging can be obtained by actually holding the currency short—or better, holding bonds and other interest-bearing assets denominated in that currency— for the duration of the futures contract. As we will see below, this ability to move assets between currencies to compensate for an imbalance in futures contracts results in a ratio between the forward rate, the spot rate and the interest rates on securities denominated in the two currencies concerned. The exchange rate between US$ and UK £ was £1.55 per £ on 1 January 2012. This is our spot exchange rate.
The inflation rate and the interest rate in the United States were 2.1% and 3.5%, respectively. Inflation and interest rates in the UK were 2.8% and 3.3% respectively. People involved in international transactions can wear three hats. They can hedge themselves by always maintaining a hedged position— that is, whenever they enter into a future commitment to pay foreign currency or a future right to receive a foreign currency, they can buy or sell the currency to ensure that their assets and liabilities, measured in local currency, are known with certainty. Or they may speculate either by not hedging in the normal course of their business or by intentionally buying or selling foreign currencies to take an unhedged position, or by exploiting spot or forward rate spreads between currencies through arbitrage. A forward foreign exchange contract is identified as an agreement between two parties with the intention of exchanging two different currencies at some point in the future. In this situation, a company enters into an agreement to purchase a certain amount of foreign currency in the future at a previously agreed fixed exchange rate (Walmsley, 2000). The move allows the parties involved in the transaction to improve their future and budget for their financial projects. Effective budgeting is facilitated by an effective understanding of the specific exchange rate and the transaction period of future transactions. Forward exchange rates are created to protect the parties involved in a transaction from unexpected adverse financial conditions due to fluctuations in the foreign exchange market. In general, a forward rate is usually set for twelve months in the future, in which the world`s major currencies are used (Ltd, (2017).
Commonly used currencies include the Swiss franc, euro, US dollar, Japanese yen and pound sterling. Forward foreign exchange contracts are mainly concluded for speculative or hedging purposes. The forward rate (also known as a forward rate or forward rate) is the exchange rate at which a bank agrees to exchange one currency for another at a future time when it enters into a future contract with an investor. [1] [2] [3] Multinational corporations, banks and other financial institutions enter into futures contracts to use the forward rate for hedging purposes. [1] The forward rate is determined by a parity relationship between the spot rate and interest rate differentials between two countries, reflecting an economic equilibrium in the foreign exchange market that eliminates arbitrage opportunities. At equilibrium and when interest rates vary from country to country, the parity condition implies that the forward rate includes a premium or discount that reflects the interest rate differential. Forward exchange rates have important theoretical implications for forecasting future spot rates. .