Answer 6(Spot rate and Forward Rate)
The spot rate is defined as the current exchange rate. On the other hand, a forward rate is the rate that is agreed by both the buyers and the sellers to be applied in the future in forward transactions. Currency movements do not affect the forward rate. The main relationship between the forward rate and the spot rate lies in the calculation of the rate. The forward rate is calculated by either adding or subtracting a premium or discount from the spot rate. The premium or discount arises as a result of the discrepancies between the interest rates of the two prime countries entering into the agreement. The use of a forward rate is to hedge against any possible losses that may accrue to the investor in the near future. Therefore, by having risk arbitrage between the two parties, investors are able to hedge against any fluctuations in the currency interest rates as well as earn interest that arises out of the discrepancies of the two currencies. These two reasons explain the relationship there is between the forward and spot rates.
Speculation is of the essence in the forward markets as it assists in earning more profits as well as speculating the exchange risk and avoiding it. There are two major strategies that are used by speculators in the forward markets. If the current is expected to appreciate or rise in value, speculators in the forward markets will buy the currency at the current local price. The investors later sell the currency when the exchange rate rises. The difference in the rates is the money earned by the speculators. The second strategy that speculators apply in the forward market is noticed when the value of a currency is expected to fall. In this case, the speculators sell the currency at the current price to and then buy it later when the value falls. This helps them fulfill their forward contracts. There are other major ways that can be used in speculation of the possible changes in the exchange rate. The factors are classified into two broad categories, namely, the economic factors and the non-economic factors.
Under the economic factors, a factor as a superfluous in the equilibrium of payments of a given state is one factor that may lead to an upward trend in the exchange rates. Levels of inflation in the state also affect the exchange rates. A state with high inflation rates experience low domestic exchange rates. If the interest rates of a country also go up, the exchange rates go up, as well. Countries with high economic growth depict similar characteristics in the exchange rates as they tend to go up. Some of the non economic factors that can be used in speculating the forward rate in the nation include political stability, expectations of the residents, as well as government and central bank intervention in the financial matters of the nation. News and information available also are critical in speculation. The positivity and negativity of such a non-economic factor are what affect the exchange rate, either positively or negatively.
Distinguish between stabilizing speculation and destabilizing speculation. Stabilization speculation occurs when the speculators buy a specific currency that is experiencing a downward movement at a low price hoping that the currency will recover and increase in price. After the increase in currency prices, speculators then sell the currency at a profit. Stabilization speculation has major impacts on the exchange rates due to the constant buying and selling, thus increasing stability of the rates. Destabilization speculation is described as the movements in the prices of a currency in the market the moment speculation occurs.
If the exchange rate adjusts from $1.70 = 1 pound to $1.68 = 1 pound, this means that the dollar has appreciated with relation to the pound. This means that an investor requires fewer amounts of dollars to purchase the pound. For the pound, this means that it has depreciated with respect to the dollar. If the exchange rate adjusts from $1.70 =1 pound to $1.72 = 1, this means that the dollar has lost value and depreciated with respect to the pound. A person in the exchange market will now require more dollars to purchase one pound. For the pound, this means that it has appreciated in value compared to the dollar.
Suppose the spot rate is $1.70 today. A three month forward rate is $1.75.
If an importer in the US has to pay 20000 pounds in three months and hedges his risk;
The only viable way that the importer can hedge him or her risk is by purchasing a three months forward rate for his 20,000 pounds today. He or she will incur the cost of $1.75* 20000= $35,000. When the three months expire, the amount of money the investor will pay will still be $35,000. In the case of a decrease in the spot rate in three months, the investor can make a profit.
b) If the importer fails to hedge against the risks and the spot rate rises to $1.80, the investor will incur more money in fulfilling the contract. He or she will incur a loss due to an increase in the spot rate.
The real interest rate is the interest that is calculated and adjusted for any inflation rates in the country. The real interest rate gives a clear return rate as the levels of inflation in a nation influence the purchasing power of that currency. Investors are interested in having a full return of the money they invest in the foreign nation and inflation plays a great role in its determination. Investors are, therefore, concerned with the real interest rate as it shows the true picture of the economic status of the nation. The nominal rate is an interest rate that has not been adjusted for inflation.
Purchasing-power-parity theory is a theory that explains how exchange rates can be predicted in the future. The predictions that the theory make with regards to inflation include that inflation rates affect the exchange rate. The theory explains that the higher the rate of inflation of a given state, the lower the purchasing power of the domestic currency. This theory predicts that the exchange rate of a country is directly affected by the inflation rates. Some limitations of the purchasing-power-parity theory include import and export restrictions. Tariffs and quotas affect the exchange rates that this theory cannot explain. Travel costs are also limitations to the theory. The prices of products between markets will differ if the cost of transport different regardless of the currency used. Government intervention is also a limitation that affects the exchange rates. Short term determination of interest rates is difficult using this theory and this is also a limitation.
In the long run, the merit of a currency either increases or decreases. The change is caused by a few factors that affect the currency in the long run. Some of these factors will include the relative price levels of the currency and the relative production levels of a country. The relative price levels affect the currency value through inflation. If the inflation prices go up, the prices increase and the currency value decreases. The relative production levels affect the currency value through production. High production means a decrease in prices and this translates to currency appreciation in the long run. Other factors will include domestic or foreign products demand, non economic factors as political and social stability.
Answer 6(Short-run Currency Valuation Determinants)
In the short run, currency values change as a result of a few listed factors. The expected rate of return on investment leads to a change in value of the currency in the short run. If the rate of return is high, investors will flock into the nation leading to currency appreciation. Risk and investment diversification is also a major determiner of the currency value in the short run since strong investments lead to currency appreciation. Expected changes in the foreign exchange rates also affect the value of a currency. The trends play a major role in determining the currency value in the short-run.
Rate of inflation is 10% in the US, 4% in the UK,
Calculate the real interest rate in each nation
So, US real interest rate = 8%- 10% = -2%
UK real interest rate = 6%-4% = 2%
The direction which investors are expected to flow with respect the interest rates is from the United States to United Kingdom. The flow would affect the price of the dollar with respect to the pound. This is because investors are more attracted to the nation with a high rate of interest, thus decreasing the value of the currency of the dollar in the United States.
Finance Train. (2014, May 25). How To Calculate Spot and Forward Rates. Retrieved May 25, 2014, from http://financetrain.com/how-to-calculate-forward-rates-from-spot-rates/: http://financetrain.com
Yahoo Finance. (2014, May 25). How To Calculate The Real Rate of Interest. Retrieved May 25, 2014, from https://answers.yahoo.com/question/index?qid=20130607180650AASCFjU: https://answers.yahoo.com