- This topic has 1 reply, 2 voices, and was last updated 11 years ago by
.
- Posts
hello Sir,
plz explain following linesInterest rates
The difference between spot and forward rates reflects differences in interest rates. If this were not so, then
investors holding the currency with the lower interest rates would switch to the other currency for (say)
three months, ensuring that they would not lose on returning to the original currency by fixing the exchange
rate in advance at the forward rate. If enough investors acted in this way (known as arbitrage), forces of
supply and demand would lead to a change in the forward rate to prevent such risk-free profit making.Forward rates offered by the banks are not the banks ‘guess’ as to what will happen to the exchange rate in the future – they are determined by the relative interest rates.
It is hard to explain why in words. To see exactly what I mean you should watch my lectures on foreign exchange risk management. You are required for Paper F9 to understand how we can use forward rates and how we can use money market hedging to remove the risk of exchange rates changing. In the real world, the banks are using money market hedging on the money in order to be able to quote a forward rate – the forward rate is determined by the result of money market hedging.
If the forward rate did not give the same result as money market hedging, then we would be able to make profits by doing both.
(If you understand forward rates and money market hedging then the above should make sense. If not then do watch the lectures.)
- You must be logged in to reply to this topic.