International Financial Management: Forward Exchange Rate and Spot Exchange Rate - Essay Example

? International financial management School Affiliation Definition of terms In order to get a better understanding of the concept under discussion in this paper, it is necessary to define two concepts that will be in use throughout this report. These terms are “forward exchange rate” and “spot exchange rate” as used in the field of international financial management. Whereas the spot (or nominal) exchange rate refers to the present price of a foreign exchange, a forward exchange rate refers to the future price of foreign exchange at a specified date (Bhole, and Mahakud, 2009). 2. Introduction The foreign exchange market involves the buying and selling of national currencies (Ajami, 2006). Foreign exchange market makes it possible for both private and commercial transactions including loans, investments, and foreign trade. The existence of a foreign exchange market is a result of economies employing national currencies rather than a common currency (Kumar, and Mukherjee, 2007; Butcher, 2011). If the world economy was to use a single currency, foreign markets could not be a necessity. The foreign exchange market is exceedingly active, and it is largely an over the counter market. Although the exchanges trade futures and option, a number of transactions are over the counter (Brigham, and Houston, 2009). The future expected spot price is the market's belief about an asset’s spot price in the future (Poniachek, 2012). This leads to a question of whether or not one can use the current forward price to predict the particular future spot price. A number of hypotheses have been in place to try clarifying the relationship between the expected future spot price, and the current forward price (Wang, 2009). In the field of financial economics, there has been intensive examination by researchers on the “Forward Rate Unbiased Hypothesis” (FRUH), as Kumar (2011) indicates. This hypothesis is based on the supposition that, in the exchange rate market, organizations or individuals work in advance to sell or buy foreign exchange at a preset rate for making prospect international payments. There is a hypothesis that this pre-determined rate of the future exchange reflects the joint wisdom of the market with regard to the spot rate that would be popular in the future. This means that organizations can look upon a future exchange rate that is prevailing today as the spot rate of the future date (Sharan, 2006; Carbaugh, 2011). In the case of an assumption that the forex market is rational or efficient, the spot rate that is common at the future date should be in tandem with the future rate for that date established in the market today. Contrary to this belief, scientific evidence indicates that there are significant variations between the forward market rates and the spot rates (Kumar, 2011). In addition, the studies have not been able to produce any material evidence to prove that forward market rate can predict the future spot rates. Some forecasters hold the believe that foreign exchange markets for the principal floating currencies are efficient, and that forward market rates are an unbiased indicators of the future spot exchange rates. Unbiased prediction implies that the forward exchange rate will, on average, underestimate and overestimate the actual future spot exchange rate in equivalent degree and frequency. There is a probability that the forward market rate may not be equivalent to the future spot exchange rates. This relationship’s rationale is founded on the assumption that: a) There is a quick reflection of all relevant information in both the forward exchange markets and spot exchange markets b) Instruments that are denominated in the various currencies are perfect alternates for each other c) Operation costs are minimal 3. The future spot rate and the forward rate One can make out the relationship between the forward market rate and the expected future spot rate on the unbiased forward rate theory. This theory claims that the forward exchange rate is the superlative, and a balanced, approximation for making out the predictable future spot exchange rate. The theory has its basis in the efficient markets theory, and it has made to be an issue of contention as an accurate explanation (Boettke, 2010). The predictable rate is only a standard, but the theory of efficient markets indicates that it is a neutral expectation that there is an equal possibility of the real rate being higher than or lowers than the anticipated price. One can simply state the unbiased forward rate theory as: The anticipated exchange rate = the forward exchange rate In order to get an apparent understanding of the theory, it paramount to explain the efficient markets theory that forms the basis of this theory of unbiased forward rate theory. 4. The efficient market theory The efficient market theory is a hypothesis that is crucial in the paradigms of modern international finances. This theory, over time, has become the basis of a number of financial models and has formed the foundation of the investment strategies for many corporations and individuals (Palan, 2007). The theory upholds that in an efficient market, there has to be availability of valuable and relevant information about the future. The theory also assumes that no investors can foretell the future or the direction that the market will take because of past events. According to Ang, Goetzmann, and Schaefer (2011), recent advances in the theory have made the hypothesis more realistic than it was initially by providing an explanation of the sources of the information and the mechanism that causes the information to be reflected in the prices. According to, A. C; Lee, J. C; Lee and C. F Lee (2009), there are a number of assumptions that must hold for the theory to be true. The first is that there has to be an entrance of new information independently and randomly over time. Second, there has to be a large number of profit-maximizing investors whose interests are independent of each other. Third, at any point, security prices should reflect without bias all the available information. Lastly, all investors adjust security prices accordingly when they receive new information as quickly as possible. 5. Analysis When speculators think that the forward rate is higher than their expectation of the future spot rate, they will have the temptation to sell the foreign currency forward. This speculative business deal will bid down the forward rate to the extent that it is equal to the speculated future spot rate. Similarly, if speculators foresee a lower forward rate than an expected future spot, they will purchase the foreign currency forward. This transaction will bid up the forward rate to the position that it is equal to the expected future spot rate. A lack of a predictable exchange market intervention in the central banks makes forward premiums or discounts, an anticipated rate of shift in a spot rate and differential rates of national interests and inflation directly proportional to each other (Kim, 2005). Due to efficiency of capital, exchange markets, and money, the variables change remarkably swiftly to any variations in any one of them. This makes the forward rate the best predictor of the future spot rate. In the discussion that follows, there is the use of forward rate parity theory to analyze the degree to which the forward market is an unbiased predictor of the spot market. The forward rate parity theory maintains that forward rates are unbiased predictors of future spot exchange rates. This means that the forward rate of a given currency, in relation to another, indicates the future spot exchange rate of the market. One can represent this relationship between the forward rates and the spot rates in the following manner (Siddaiah, 2009): Ft(X/Y) = ESt(X/Y) Where; Ft(X/Y) is the forward rate of a single unit of currency X in terms of Currency Y for delivery in t days or months, and ESt(X/Y) is the anticipated spot rate of a single unit of currency X in terms of currency Y on the date of maturity of the forward contract. The purchase and sale of foreign currency in the forward market will affect the future spot rates in the sense that the squaring of forward contacts at maturity will exert pressure on the future spot market. This means that there is a transmission of pressure from the forward market to the spot market thereby influencing the spot rates. On the other hand, the future spot market has the capacity of exerting pressure on the forward market, which in turn influences the forward rates. At the point when the forward rate is neither greater nor lower than the predicted future spot rate, the future expected spot rate and the forward rate are in equilibrium, meaning that Ft = E (St). In this case, businesses will not have the incentive to buy or sell the currency forward (Johnson, 2010). At the state of equilibrium, the forward rate differential is equal to the predicted rate of change of the spot exchange rate, thus (Siddaiah, 2009): (Ft - So)/So = {E (St) – So}/So An example of an equilibrium state of the future expected spot rate and the forward rate is when the market expects 5% depreciation of a foreign currency, but predictors are selling the currency at 5% forward discount. However, if the future expected depreciation rate of a foreign currency is 5% and speculators are selling the currency at 3% forward discount, then this is a stet of disequilibrium. When the two variables are in equilibrium, the interest rate differential between two different currencies is equivalent to the anticipated rate of shift in the spot rate, a relationship referred to as uncovered interest rate parity (Diez De Los Rios, and Sentana, 2011). The case above will apply in an ideal environment since in reality the scenario it might vary. This simply means that the forward rate may not exactly indicate the expectation of the future spot rate due to the risk premium on the forward contract (Siddaiah, 2009). This will result in the difference between the forward rate and the expected future spot rate, leading to deviation from the parity line. Current expectations of future events influence the future spot rate and the forward rate (Kim, 2011). When people get new and sufficient information, they renew their expectations regarding future events, resulting in shifts in the exchange rates (Kumar, 2011). To get a clear understanding of the idea that the Forward Market is an unbiased predictor of the Spot Market, consider the following example: a) The current spot rate for the Swiss Franc is SFr 1 = $ 0.4500 b) A one-year forward rate for the Swiss Franc is: SFr 1 = $ 0.4000 c) The expected spot rate in one year for the Swiss Franc is: SFr 1 = $ 0.4000 d) The expected rate of inflation for one year: Switzerland = 10%, US = 5% e) The interest rates on one year government securities: US = 7%, Switzerland = 12% This implies that: The forward discount = {(n-day forward rate – spot rate)/spot rate} ?360/n = {($ 0.4000 - $ 0.4500)/ $ 0.4500} ?360/360 = - 0.11 or 11% Under a freely floating system, the forward rate is an unbiased predictor of the future spot rate. Based on the above example, the one-year rate of $ 0.4000 for the Swiss Franc is equal to the expected spot rate of $ 0.4000. This implies that the 11 per cent one-year forward discount for the Franc is an unbiased predicator that the Franc will depreciate by 11% over the next year. This example illustrates the relationship that exists between the forward rates and the expected future spot rate (Kim, 2011). This is a useful theory for businesses if they are able to predict the expected future rates using the current forward price. However, most studies indicate that this should not be often the case, as changes in the spot exchange rates do not have a close relationship with the forward exchange rates. As a result, a number of practitioners and researchers agree that it is almost impossible to foretell how much exchange rates will move in numerous times, particularly in the short run (Megginson, and Smart, 2009). As stated earlier, the hypothesis that the forward rate is a neutral indicator of the future spot does not always hold. A rejection of this hypothesis could be a consequence of any or both of the following situations: a) There is risk neutrality b) The expectations are not rational Based on the efficient market theory, it is imperative to state that the theory that the forward predicts the condition of the spot market will not hold, if any of the conditions stated earlier do not hold. The hypothesis holds that, over time, there has to be an entrance of new information independently and randomly over time. If there is no entrance of this kind of information that is valuable and relevant, then the forward market cannot predict, with accuracy, the future spot market. In addition, if the activities of profit-maximizing investors affect each other then this hypothesis will not hold. If the security prices do not offer unbiased reflection of all the available information, then the forward market prediction will give a biased expectation of future spot prices. Lastly, all investors need to adjust security prices accordingly as soon as they receive this information to enable the investors predict the future accurately. One way to examine evidence is to analyze the relationship between the actual alteration in the exchange rate (et+1?et) and the forward discount (Ft?et). In this case, one might expect that the former will be more prevalent than the former, but this is always not the case as there is no systematic connection between the two. If one plots this relationship, the presence of the noise is evident although the deviations do not appear random. According to the theory, the difference between these two variables is a random error indicating that in this scenario the hypothesis does not hold. 6. Conclusion In efficient markets scenarios, market agents process information reasonably and integrate current and past information into asset prices (Harder, 2010). In that sense, only latest information, or news, has the capacity to cause changes in prices. Since, one cannot forecast news; it means that price changes should be predictable; no information at time should be useful in improving the forecast of prices (Read, 2013). In such efficient markets, the availability of derivatives markets is useful in helping to find out prices, which are likely to rein in the spot market. In the case of efficient markets, according to the efficient markets hypothesis, forward contract prices must be neutral estimators of the spot prices of the core asset that will be realized at the conclusion date (Harel, Harpaz, and Francis, 2011). If future exchange rates are on average equal to the corresponding forward exchange rates exactly, this means that the forward exchange rate is a precise and an unprejudiced indicator of the future spot exchange rate (Kouvelis, 2011). 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