Foreign Exchange Market

Prof. Abhinav Sharma

Assistant Professor (Finance)
Goa Institute of Management
India

August 29, 2023

Forward Contract

Suppose Himanshu is a trader. He expects to receive USD 1000 in three

months from now. However, he is not sure about the actual value in INR he
would receive from selling the USD in three months. What do you suggest to
Himanshu?

Suppose Pranjal is planning to buy an IPAD from the US in three months. The
IPAD currently costs around USD 1000. However, she is not sure about the
actual value in INR she needs to pay in three months to buy the IPAD. What
do you suggest to Pranjal?

Forward contract is a privately negotiated contract between two counterparties

to trade an asset/security at a specified price and at a specified date in the
future.

Both the parties have obligations to honor the contract at the predecided terms
and conditions in the future.
Forward vs Futures Contract

Futures contract is similar to the forward contract, only

difference being its standardized nature.

Futures contracts are traded on futures exchange at specified

prices and lot sizes with a margin amount (as collateral).

Since the exchange is the intermediary between the two

counterparties, there is no counterparty risk in the case of
futures contract.
Foreign Exchange Market : Some Terminologies

Direct Quote vs Indirect Quote

Spot Rate vs Forward Rate of exchange.

Forward Premium vs Forward Discount

Currency Spot Rate 1 Month 3 Months 6 Months

USD 68.21 68.52 69.06 69.82
EURO 72.64 73.05 73.87 75.05
Relationship 1: Interest Rates and Exchange Rates

Interest Rate Parity Theory

Suppose you have Rs1000 to invest for 6 months. Indian

rupee deposits are offering 6.1% p.a; US deposits are offering
1.24% p.a. Where should you put your money?

Difference in interest rates must equal the difference between

the forward and spot exchange rates.

1+Indian Interest Rate Forward rupee exchange rate

1+U.S Interest Rate = Current rupee spot rate

If the above condition is not satisfied, there will be arbitrage

opportunity.
Relationship 2: Forward Premium and Changes in
Spot Exchange Rates

The forward rate of exchange would be determined by what

people expect the spot rate to be in the future.

If 6 month forward exchange rate is 69.82, then this means

that people expect the spot rate of exchange to be 69.82 in 6
months.

Forward rupee exchange rate Expected rupee spot rate

Current rupee spot rate = Current rupee spot rate
R3: Inflation Rate and Spot Exchange Rates
Suppose silver can be bought in the US for USD 1000 a troy
ounce, and it can be sold in India for Rs 90, 000. The spot
exchange rate is Rs 68.210/USD.

No arbitrage opportunity ensures that the USD price of silver

when converted to INR must be the same as the price of
silver in India.

INR price of goods in India = USD Price of goods in the US

× Spot Exchange Rate of INR/USD

Purchasing power parity implies that any difference in the

rates of inflation will be offset by a change in exchange rate.

1+Expected Indian Inflation Rate Expected rupee spot rate

1+Expected U.S Inflation Rate = Current rupee spot rate
R4: Interest Rates and Inflation Rates

Investors care only about the real interest rates rather than
nominal interest rates.

If real interest rates are higher in India then investors will shift
their money into India and vice-versa.

This implies that the real interest rates must be equal in both
countries.

As per Fisher Theory, (1 + rnominal ) = (1 + rreal )(1 + inflation)

1+Nominal Indian Interest Rate 1+Expected Indian Inflation Rate

1+Nominal U.S Interest Rate = 1+Expected U.S Inflation Rate
Four Inter-Relationship

If any of the four relations are not satisfied, we will have an

arbitrage opportunity, which cannot exist for long.
References

References I

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