Objectives of the Chapter

This chapter extends the discussion of exchange rates begun in Chapter 17 by explicitly introducing the aspect of future exchange rate changes and the risk posed by rate fluctuations. Contracts to exchange currencies in the future, at a price determined in the present, are called forward contracts. These contracts can be used both by people wishing to avoid uncertainty and by people who are willing to take on risk by betting on the future movements of exchange rates.

This chapter will be of particular interest to those wishing to predict the future and to those hoping to make a quick buck off their studies. We show that, in theory, the actions of agents speculating in exchange markets can cause the forward exchange rate to approximate what the average market participant thinks the spot exchange rate will be in the future. Furthermore, our models tell us that the actions of more risk-averse investment types should produce covered interest parity, in which the ratio of today’s forward rate to today’s spot rate equals the ratio of (1 + the home country’s interest rate) to (1+ the foreign country’s interest rate). Then, if the forward rate does accurately predict the future spot rate, we have uncovered interest parity, in which the interest rate ratio equals the ratio of the expected future spot rate to today’s spot rate.  

After reading Chapter 18 you should be able to

1.    differentiate between spot exchange rates and forward exchange rates.

2.    understand the use of forward rates to hedge and to speculate.

3.    explain the relationship between the forward exchange rate and the expected future spot rate.

4.    explain the relationship between the spot rate, the forward exchange rate, and international interest rates.