EXCHANGE RATE

FORECASTING-
FORWARD RATES
Kaushal Verma (20096)
Ashish Singh (20041)
Meaning Of Exchange Rate Forecasting
1) It refers to the estimations of the future levels of the exchange rate over a certain
time period they are mostly undertaken by economists and currency analysts
working for portfolio management firms and investment banks

2) Exchange rate forecasts are for the most part based on expectations regarding
macroeconomic variables, interest rate differentials, sentiment, and even political
events.
 HEDGING DECSIONS

SHORT TERM FINANCIAL

DECISIONS

Why Organizations
SHORT TERM INVESTMENT
need to Forecast DECISONS
Exchange Rates?
CAPITAL BUDGETING
DECISIONS

EARNINGS ASSESSMENT
Models For Exchange Rate Forecasting
1) PURCHASING POWER PARITY

2) INTEREST RATE PARITY

3) MONETARY MODEL

5 PORTFOLIO BALANCE APPROACH

 Interest rate that will be paid
on a investment made in the
future.
MEANING OF Mechanism for hedging those
future interest rates
FORWARD
RATES Aids in making Invesment
decisions

Just an estimate
 Formula of Forward
Rate
((1+Ra)Ta/(1+Rb)Tb – 1)
Where,
Ra = Spot rate for the bond
with maturity period Ta
Ta = Maturity period for
one term
Rb = Spot rate for the bond
with maturity period Tb
Tb = Maturity period for the
second term
EXAMPLE
SUPPOSE PERSON A BUYS A FIVE-
YEAR BOND WITH AN ANNUAL
YIELD OF 8% AND A THREE-YEAR
BOND WITH AN ANNUAL YIELD OF
6%. SHE USES THE FORWARD
RATE FORMULA TO ESTIMATE THE
FUTURE VALUE AND DECIDE
WHETHER TO INVEST IN IT OR
NOT.
FORWARD RATE =
((1+RA)TA/(1+RB)TB – 1) =
((1+0.08)5/(1+0.06)3 – 1)
= 0.233692695
= 23.37%
Mechanism of Forward Rates and
Spot Rates
Relationship between Forward Rate and Spot
Rate
It refers to the relationship between the current market
price of a financial asset, known as the spot rate, and the
price that market participants expect the asset to be worth
at some point in the future, known as the forward rate

DIFFERENCE BETWEEN FORWARD RATE AND

SPOT RATE

The difference between the spot rate and the forward rate is
called a forward premium or discount

If the forward rate is greater than the spot rate it indicates

that the prices of the assets are going to rise and vice versa
 Forward Rate is equal THE US DOLLAR-
to the spot rate *(1+ TO EURO
domestic interest EXCHANGE RATE
rate)/ (1+foreign
CALCULATION OF interest rate)
IS $1.2568

FORWARD RATE
FROM SPOT RATE
THE DOMESTIC
INTEREST RATE IS
F= $1.2568* 4% AND THE
(1.04/1.0375) =$1.2598 FOREIGN
IT clearly reflects a INTEREST RATE IS
forward premium 3.75%
KEY DIFFERENCES BETWEEN FORWARD RATE AND FUTURE SPOT
RATE

FORWARD RATE FUTURE SPOT RATE

Price that market participants agree to The actual price of the asset at a future
exchange a financial asset at a future date
date.

Represents the expected value of the
asset at a future date, based on the
current spot rate and expected interest
rate differentials
.
Represents the value of the asset as it is
traded in the market at that future point
in time.
 FORWARD RATES: AN
UNBIASED PREDICTOR OF
EXCHANGE RATES
 WHAT DO WE MEAN BY UNBIASED
FORWARD RATE?
1) The forward exchange
rate, quoted at time t
for delivery at time t+1,
is used as an unbiased
predictor of the
expected value of the
spot exchange rate at 2) Does Not imply that
time t+1 the future spot rate will
actually be equal to
what the forward rate 3) The forward rate will,
predicts. on average, overestimate
and underestimate the
actual future spot rate in
equal frequency and
degree.
KEY
TAKEAWAYS

FORWARD RATES ARE NOT EQUAL TO

FUTURE SPOT RATES

SUM OF THE ERRORS EQUAL ZERO

 PROBLEMS WITH USING FORWARD RATE TO
FORECAST EXCHANGE RATE

DOES NOT INCORPORATE RISK PREMIUM IN FORECAST

IT IS JUST A HYPOTHESIS, AND EMPIRICAL EVIDENCE IN THE LAST FEW

DECADES HAS SHOWN MIXED RESULTS

MOREOVER, UNBIASED FORWARD RATES OCCUR UNDER THE ASSUMPTION

OF EFFICIENT MARKETS HYPOTHESIS, WHICH REQUIRE FINANCIAL
MARKETS TO BE INFORMATIONALLY EFFICIENT
 If economic agents are risk
neutral

WHAT MAKES
Market is competitive and all
FOREIGN information is available freely

EXCHANGE
MARKETS All available information is
used rationally
EFFICIENT?
There are no taxes, transaction
costs, or other frictions
 Forward rates may be useful in certain situations, such as
for hedging purposes or as a basis for pricing financial
instruments, but they should not be the sole basis for
making investment decisions.

CONCLUSION
Even though forward rates as a model for forecasting
exchange rates are essentially free and readily available,
It appears that based on empirical tests, they are not
unbiased predictors of the future spot rate and it does
pay to use resources in an attempt to forecast exchange
rates.
THANK YOU