Relationship between spot and forward rates
A study of the relationship between spot and forward rates would help in determining the degree and the extent of predictability of the former on the basis of the later.
The collective judgment of the participants in the exchange market influences the appreciation or depreciation in the future spot price of a currency against other currencies.
The forward premium or discount is also affected by the interest rate differential between two countries, differences in the rates of inflation between them, and the degree to which inflation rate differential is translated into interest rate differential in the expected time horizon.
Moreover, the relationship between spot and forward rates may be affected by the efficiency of the financial and exchange markets in two countries. Controls, restrictions and other interventions which can affect adjustments in exchange, and interest and inflation rates differential also influences the spot and forward rates.
Theoretically, in the efficient market and absence of intervention of control in the exchange or financial markets, the forward rate is an accurate predictor of the future spot rate. These requirements are, generally, satisfied if the following three conditions are found:
1. Interest rate parity in spot vs forward:
According to interest rate parity principle, the forward premium (or discount) on currency of a country vis-a-vis the currency of another country will be exactly offset by the interest rate between the countries. The currency of the country with lower interest rate is quoted at a forward premium and vice-versa.
2. Purchasing Power Parity (PPP) in spot vs forward
According to the PPP Principle, the currency of a country will depreciate vis-a-vis the currency of another country on the basis of differential in the rates of inflation between them. The rate of depreciation in the currency of the country would roughly be equal to the excess inflation rate in the country over the other country.
3. International Fisher Effect in spot vs forward rates:
The interest rate differential between two countries, according to the Fisher effect, will reflect differences in the inflation rates in them. The high interest country will experience higher inflation rate.
It should, however, be noted that even if these conditions are satisfied, the future spot rate might not be identical to the forward rate. Random differences between the two rates may be found.