What is a forward rate?
The N-day forward rate is the rate which appears in a contract to exchange a currency for another N days in the future. It is distinguished from the spot rate. which is the rate used in agreements to exchange one currency for another immediately. No currency changes hand between the parties in a forward contract at the time it is signed; the currency is exchanged at the maturity date of the contract N days in the future.
What is a forward premium (forward discount)?
A forward premium (forward discount) is the proportion by which a country's forward exchange rate exceeds (falls below) its spot rate.
What are the determinants of the forward premium?
The forward premium (or forward discount if the number is negative) is determined by the interest rate differential between the United States and Canada. According to the Interest Rate Parity theorem, the expected appreciation of the Canadian Dollar is equal to the difference between the U.S. and Canadian interest rate. For example, if the interest rate in Canada is one percent higher than in the United States, over a period of one year the Canadian Dollar will tend to depreciate by one percent. Note that a raise in Canadian interest rates first lifts the exchange rate, and only then the CAD starts to depreciate. The interest rate differential is based on comparable assets (with risk premia already factored in), for example, Canadian and U.S. 90-day or 1-year treasury bills.
Is the forward rate a good predictor of the future spot rate?
No. For example, the relationship between today's 90-day forward rate and the spot rate three months from now is very
weak. It is not even a good predictor of the direction, if not the magnitude, of the expected change. Thus a forward rate cannot be used to predict future exchange rates.
What is the forward rate used for?
Insurance against exchange rate risk can be obtained through contracts in the forward market. Such activity is called hedging. A hedge is the offset of a given position in a separate bu parallel market by an equal and opposite position in which the effect of the offset reduces or eliminates the effects of a value change in both positions. In simple terms, a hedge locks in the current value in a contract. The instrument for a hedge is often a currency swap in which a spot contract is offset by an equal-amount forward contract.
Where can I get forward rate data?
The PACIFIC Exchange Rate Service publishes daily CAD/USD forward rates. In Canada, such data can be obtained from Statistics Canada, the Bank of Canada, and other commercial providers. For forward rates of other currencies please refer to commercial data providers are Bloomberg Financial Markets and DataStream.Where can I learn more about forward rates, hedging, etc?
- Richard Baillie and Patrick C. McMahon: The foreign exchange market: theory and econometric evidence . Cambridge University Press, New York, 1989.
- Laurence S. Copeland: Exchange Rates and International Finance . 4th edition. Prentice Hall, 2005.
- Peter Isard: Exchange Rate Economics . Cambridge University Press, Cambridge, 1995.
- Lucio Sarno and Mark P. Taylor: The Economics of Exchange Rates . Cambridge University Press, 2003.
- Piet Sercu and Raman Uppal: International Financial Markets and The Firm. Chapmann & Hall, London, 1995.