Forward Exchange Rate

Forward Exchange Rate

Forward Exchange Rate, the rate at which domestic currency can be exchanged for foreign currency in the forward market. The current or 'spot' exchange rate is determined by the supply of and the demand for currencies in the ordinary market for foreign exchange. In the same way the forward rate is determined by the supply of and demand for currencies in the forward market. For example, a forward rate for sterling against the dollar of 6 to i is the result of contracts entered into in the forward market. In this case since the forward rate is lower than the 'spot' rate, which is 'pegged' at 8, more pounds must have been sold forward for dollars than at the spot rate. The excess supply of pounds thus forces down the forward rate, so that the dollar gains a premium of z cents. This is how the forward market rates are normally quoted in the financial press, i.e, so many cents premium or discount. Usually two rates are quoted: the one-month rate and the three-month rate; they are the result of contracts entered into by dealers to supply dollars, lire, francs, etc., in one month or three months' time against pounds.

A forward market reduces uncertainty to traders, bankers and investors. It enables them to 'hedge' against the risk of a change in the 'spot' rate by selling (buying) in the forward market a sum equal to the amount they bought (sold) in the spot market. If a man in America with ,000 to invest for three months finds that short-term interest rates are higher in London than New York, he can convert his dollars into sterling and buy three-month Treasury bills in London, but he faces a risk that sterling may become worth fewer dollars. The interest and even some of the capital may be lost

when he re-converts into dollars. To cover this risk he can make a contract in the forward market to sell for dollars the amount of sterling he expects to have when he sells the bills. He thus knows before he enters the deal exactly how many dollars he will finally have.

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