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Forward Rates Vs Spot Rates

Forward Rates Vs Spot Rates Assignment / Homework Help
An exchange rate is the ratio of one unit of currency to another unit of currency. An exchange rate is established between different currencies to facilitate inter-country transactions. The conversion rate between various currencies depends mainly upon the demand and supply relationships. Because exchange rates are fluctuating in nature, companies and dealers are subject to exchange rate fluctuation risks. There are two important types of exchange rates that prevail in a foreign exchange market. They are the Spot Exchange rate and the Forward exchange rate.

Spot exchange rates are the rates that are applicable for purchase and sale of foreign exchange on spot delivery basis or immediate delivery basis. Although, the term spot denotes immediate happening and closing of transaction, practically it takes two business days for a spot exchange transaction to get settled. So, we can say that the Spot rate is the rate of exchange of the day on which the transaction has occurred and of the days the execution of the transaction is taking place.

Forward exchange rates, in contrast, are the rates that are applicable for the delivery of foreign exchange at a certain specified future date. For example, a foreign exchange contract may specify that the payment has to be settled after 3 months, or it may be a 90-day maturity contract. When a contract is agreed upon, the dealer of the foreign exchange settles the payment due after the 90-day period at the agreed forward exchange rate. This settlement will be at the initially agreed rate, called forward exchange rate, and will not be affected by the spot exchange rates prevailing at the time of settlement at maturity. This is a way by which uncertainty and risk could be avoided in dealing with foreign exchange transactions.

Forward rates may be greater than the current spot rate or less than the current spot rate. The forward exchange rate of a currency will be slightly different from the spot exchange rate at the present date due to uncertainties and future expectations.

Example:

Currency Contract U.S. Dollar Equivalent Currency per U.S. Dollar
  U.K (Pound) Spot 1.6181 0.6180
30-day maturity (future) 1.6161 0.6188
60-day maturity (future) 1.6150 0.6192
90-day maturity (future) 1.6070 0.6223

In the above table, a rate of 1.6181 per British pound means each British Pound costs the U.S. Company $0.6180. Exchange rates may be in terms of direct quotation or an indirect quotation. In the above example, $0.6180 = 1 British Pound is a direct quotation for British Pounds in the USA.

Indirect quotation = 1/Direct quotation

Indirect quotation = 1/$0.6180 = 1.618.

Therefore, British pounds 1.618 = 1 U.S. Dollar is an indirect quotation for British pounds in the USA.

Cross Rates

Cross Rates are used when a direct quote of the home currency or any other currency is not available in the foreign exchange market. Cross rates are the exchange quotes of other pairs of currencies. It is defined as the rate of exchange of two currencies on the basis of exchange quotes of other pairs of currencies.

Example:

Given:

New Zealand Dollars per U.S. Dollar = 1.7910 1.8520

Indian Rupee per U.S. Dollar = 48.0455 48.2121

Now, let us determine the exchange rate between Indian Rupee and New Zealand Dollars for an importer in India, who is to pay by NZD.
  • In this case, the dealer bank's U.S. Dollar's selling rate is 48.2121/US $ and buying rate is INR 48.0455/US $.
  • Now, the importer needs to buy US $ first, at the rate of INR 48.2121 per US Dollar.
  • Secondly, he needs to sell the U.S. $ to purchase New Zealand Dollars. The selling rate for U.S. Dollars would be the buying rate of the dealer bank, i.e., NZD 1.7910 per U.S. Dollar.
  • So, the Indian importer finally gets NZD 1.7910 in exchange for INR 48.2121.
  • Therefore, for 1 NZD he has to pay: 48.2121/1.7910 = INR 26.9291. This is the cross exchange rate.

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