EXCHANGE RATE THEORIES 23
exchange rate variations and to predict their future course. Sev-
3 EXCHANGE RATE THEORIES
3.1 Introduction
It is necessary to know long-term future exchange rates in
order to take strategic decisions concerning investment and
management of foreign subsidiaries. These predictions of future
rates will be .~itten in the strategic plan of the group as
whole, compnsmg the parent as well as the different subsidiar-
ies: Besides long-term future rates, it is equally important to
estimate exchange rate in medium term, that is, over a period
of one year, because cash flows of subsidiaries consist of
domestic as well as foreign currencies. Short-term prediction
on the other hand, is necessary for managing exchange expo-
sure on day-to-day basis.
. Gene:ally graphs and charts are used for short-term predic-
tion while fundamentals are used for predicting medium and
long term rates. Fundamentals consist of factors like interest
rates, inflation, economic growth, and money supply. It is rea-
sonable to assume that these factors will have some impact on
e~c~ange rate. The effect of each of them may not always be
distinctly clear, yet the fact is that each of the fundamental fac-
tors has an influence on the evolution of exchange rates.
From the above, the significance of prediction of future
exchange rate is apparent. Theorists have been trying to explain
eral theories have been propounded to this effect. These theo-
ries, by and large, use factors such as inflation, interest rates
and balance of payment deficit. The two important theories
are:
(1) Purchasing Power Parity (PPP), and
3.2
(2) Interest Rate Parity (IRP).
Purchasing Power Parity (PPP) Theory
Purchasing Power Parity theory is based on the premise that
the same product cannot have different prices in two different
markets at any given point of time. This theory assumes
restriction free movements of goods and absence of incidental
costs such as transportation. According to this theory, if a
product costs Rs 100 in India and $ 2.5 in USA, then one US
dollar has to be equal to Rs 40. That is, a sum of Rs 100 has
the same purchasing power as the sum of $ 2.5.
This theory was first enunciated by Gustav Cassel, a Swed-
ish economist. He said that the purchasing power of a currency
is determined by the amount of goods and services that can be
purchased with one unit of that currency. If there are more
than one currency, the exchange rates between them should be
such that they provide the same purchasing power to different
currencies. In case the existing rate is such that purchasing
power parity does not exist, it is a situation of disequilibrium.
It is expected that the exchange rate among different currencies
conforms eventually to purchasing power parity.
Now, let us consider two countries, A and B. The rate of in-
flation are rA and rB respectively in the two countries. Let us
assume further that rA is higher than rB• Since inflation rate is
lower in country B, its goods will be relatively cheaper com-
pared to those of country A. As a result the imports of country
A from country B will increase, since the prices of foreign
goods tend to be lower for country A. Similarly, exports from
country A will decrease since the prices of its goods appear to
be higher to foreigners. This situation will not persist for long.
24 FOREIGN EXCHANGE MARKETS EXCHANGE RATE THEORIES 25

As a consequence, the currency of country A will depreciate

'with respect to the currency of country B and a new exchange or
rate will be established. PIA ( 1 + rB)
- =S X
Let us say that at pet· od 1, the price of a basket of goods in PIB 2 1 + rA
country A is PIAwhile at in country B is PIB and SI units of
currency A are equal t one unit of currency B. The relation
or
between the currencies of the two countries at the period 1 is
given by equation 3.1. SI = S2 X
C1 + r )
B
1 + rA
PIA = SI X PIB (3.1 )

At period 2, the prices of the same basket of goods are P2Aand

P2Bin the two countries respectively. The equations 3.2 and 3.3 ( 1 + rA ) (3.5)
S2 = SI x
relate the prices and inflation rates. I 1 + rB

P2A= PIA (I + rA) (3.2) The equation 3.5 is the fundamental equation of the PPP.
Thus, if the rate of inflation in country A is lower than that
and in country B, the exchange rate of period 2, S2' will reflect
appreciation of the currency of country A with respect to the
P2B= PIB (I + rB) (3.3)
currency.of country B.
From equation 3.5, one can work out the rate of apprecia-
The exchange rate and price at the period 2 are linked as
shown by equation 3.4. tion or depreciation as follows:

S2 - SI
P2A= S2 P2B (3.4)
Rate of appreciation or depreciation (d) = ---
SI
Substituting values of prices from equations 3.2 and 3.3, we
get

PIA (I + rA) = S2 X PIB (1 + rB)

1
SI ( --
1
+ rA
+ rB
-1
)

--
....
\
l-l-trA
~
_I

SI
Or
1. The rate of inflation of a country is normally calculated from the price
indices: For example, price indices are PI and P2 at the beginning of
rA - rB
(3.6a)
year 1 and year 2 respectively, then inflation rate (r) over the period d = 1 + r
year 1 - year 2 is given by equation as given below: B

P2 - PI If we consider rBto be much smaller than 1, then

r = --- x 100 per cent
PI d",,(rA-rB) (3.6b)
26 FOREIGN EXCHANGE MARKETS
.
EXCHANGE RATE THEORIES

.
27
( ~"1-/~)~ ~
!
<;. ~
Solution: Applying the PPP equation, we wnte .5.
The equation 3.6b states that rate of appreciation or deprecia
tion is simply the difference between the rates of inflation i _ ( 1 + rA )

the two countries. S2 - SI

1 + ra
Though this theory is conceptually sound, there are a nurnbe
of factors which prevent it from predicting exchange rate i Here S I == Rs 42/US $
practice. Some of the major factors in this regard are: rA == 5 per cent
rB == 3 per cent
(i) Trade restrictions,
(ii) Government restrictions on exchange rates, Then,
(iii) Continuation of long-term flows despite the disequi 1 + 0.05 )
librium between purchasing power parity and exchang S2 = Rs 42 x (
1 + 0.03
rates,
(iv) lack of definition of the relevant rate of inflation an = Rs 42.8155/US $
price .levels. For example, it is important to establis
whether price indices should be based on only thos and
commodities that are traded internationally or on a 1 + 0.05 )
commodities.
d = ( 1 - 1
+ 0.03
The PPP takes into account only the movement of goo = 0.02 or 2 per cent
and not that of capital. In operational terms, it is concerne
only with the current account segment of Balance of Paymen Thus, at period 2, the exchange rate is Rs 42.8155/US $ and
and not the total BOP. If a currency is an instrument of pa Rupee has undergone a depreciation of 2 per c.s:pt ~etween
ment for other countries, as is the case with the US dollar, the period 1 and period 2. .1 ~ ~~~
exchange rate may evolve in a manner independent of pri
level of the country concerned, i.e. USA. 3.3 Theory of Interest Ra.te Parity (IRP)
The PPP theory is ideal for predicting exchange rates i
specific situations such as high rate of inflation or monetar The basic premise of this theory is that in an open economic
disturbances. In these specific situations, the response of indi system, the real future worth of a monetary asset should be the
viduals to changes in value of real and monetary assets i same irrespective of the currency in which it is invested. As per
expected to be strong and the prediction of exchange rates b Fisher, the nominal rate of interest is related to real rate of
the PPP theory may turn out to be realistic. Example 3.1 illus interest and inflation by the equation:
trates the application of PPP theory.
(I + in) = (I + i.) (I + r) (3.7)
Example 3.1: The exchange rate between Rupee and US dolla where
is Rs 42.00/$ at period I and respective rates of inflation i in = nominal rate of interest
India and USA are 5 per cent and 3 per cent respectively. Wha
ir = real rate of interest
is the likely exchange rate at period 2 and the rate of deprecia r rate of inflation.
tion or appreciation?
28 FOREIGN EXCHANGE MARKETS
The market rate of interest is the nominal rate. The real rate·
of interest or real rate of return corresponds to increase of pur-
chasing power.
Since all financial contracts are denominated in terms of
nominal rates, the real rate should be adjusted to take into
account th~ anticipated inflation. If Fisher effect is applied to
EXCHANGE RATE THEORIES 29
obtain the same real rate of return whether he places his funds
in the currency of country A or that of B, as long as there is no
restriction on movement of capital. Let the current exchange
rate between the currencies of countries A and B be such that
5 units of the currency of A is equal to one unit of the cur-
I

two countnes, A and B, then one can write: rency of B. The nominal rates of interests are inA and inBrespec-
tively. The investor places either SI units of currency in coun-
try A or one unit of currency in country B, then he obtains
(I + inA) = (I + irA) (1 + rA) (3.8)
51 (I + inA) in country A or 1.( 1 + inB) in country B and the
(I + inB) = (I + irB) (1 + rB) (3.9) two sums obtained should be equal. That is,

According to Fisher, in the state of equilibrium, real interest (3.13)

rates in two different countries should tend to be equal because
of arbitrage process. That is, in the state of equilibrium. If the exchange rate at period 2 be S2' then one unit of cur-
I+ inA)
rency of B is equal to SI (I + i . In other words, the exchange
nB
or
rate! at period 2 is ~\ ( \ ~L <\11) _ \ ~\;t -(;"~
~>t f;,
1 + inA 1 + inB (\~l",d u
---- --- (3.10) I + inA
I + rA 1 + rB
S2 = SI --- (3.14)
I + inB
Equation 3.10 can be modified as follows:
Equation 3.14 expresses the interest rate parity relationship.
1 + inA _ I = I + inB We can further derive a relationship between interest rate
- I and variation in exchange rate (d).
I + rA I + rB
(inA - rA ) = (inB - rB) (3.11 )
or d= - I

(3.12)
2. For a period other than one year (say 0 days) equation 3.14 can be
. Equ~tion .3.11 implies that the currencies that undergo modified as follows:
higher inflation will have higher nominal rates of interest than
those which have lower inflation. While writing equation 3.11,
the values of rA and rB has been presumed to be very small in
comparison to 1.
The other stipulation of Fisher is that an investor should
52 = 5,
J +i .• x--

[ l+i
M

x~-
360
0 1
nB 360
30 FOREIGN EXCHANGE MARKETS
EXCHANGE RATE THEORIES 31

or Solution: Applying interest rate parity relationship, exchange

rate after 3 months will be

or
x [1
1
+ is X
+ iEu X
~

-
1
12
(3.15)

If we consider inB to be much smaller than 1, then variation = 1.1 x

(1 + 0lIS>< 3]
can be shown to be equal to the differential of interest rate in
~ + 006 X ~
the two countries, that is,
l.0125
d = (i nA - i nB ) (3.16) = 1.1 x 1.0973
l.015
The theory of Interest Rate Parity and Fisher effect have or
been tested. It is found that the countries that have higher rate S2 = $ 1.0973/Euro
of inflation have higher nominal interest rates. Thus, it seems As is expected, Euro has depreciated marginally vis-a-vis
that the major part of variations of nominal interest rates can
dollar.
be attributed to the anticipated difference of inflation rates.
Yet, it is not easy to test the hypothesis of equality of real inter- 3.4 Fundamental Analysis
est rates.
Integration of capital markets brings in some degree of homo- As we have seen, PPP and IRP are able to quantitatively link
geneity of interest rates. If the capital markets were integrated, future exchange rate with inflation rate and interest rate
there would be a global demand of funds against a global sup- respectively. But these two theories do not capture exchange
ply and thus a rate of interest will result from equilibrium of rate changes in totality. It is so because exchange rates are
demand and supply. On the contrary, when markets are seg- influenced, in a very complex way, by many economic factors,
mented, demand and supply are determined at the level of collectively known as fundamentals. An analysis of how these
each country as a function of its specific conditions and hence factors affect exchange rate is called fundamental analysis.
theory of interest parity is not fully verified. The differences Some of these factors include:
that exist between real interest rates may be either due to
exchange risk or political risk. (i) Balance of payments,
(ii) Inflation rate,
Example 3.2: The current exchange rate between US dollar and (iii) Long-term as well as short-term interest rates,
Euro is $ 1.l/Euro. Three-month interest rates in USA and (iv) Monetary policy,
Euro-zone are 5 per cent and 6 per cent respectively. What is (v) Budgetary and fiscal deficit,
the exchange rate expected to be after 3 months? (vi) Evolution of GDP,
32 FOREIGN EXCHANGE MARKETS
(vii) Borrowing by household sector,
(viii) Indicators of demand, such as orders for durable
goods, capital investment, retail sales, wholesal-
orders, and housing market, and
(ix) Indicators pf supply, such as industrial production,
use of the capacity of production, employment mar.
ket and capital market.
Most of these factors are inter-dependent in a rather com.
plex manner. Therefore, it is not easy to develop precise math.
ematical equations linking future exchange rate with each one
of these factors. However, mathematical models can be devel-
oped and verified on empirical data to see which factors have
had more significant influence on exchange rates than others
aver a given period of time. We have already seen how infla-
tion and interest rates are linked to exchange rates. Other fac-
tors enumerated can be discussed in qualitative terms.
For example, balance of payments comprise trade balance,
balance of services and invisibles, and balance of capital in short
term as well as long term. The current and capital accounts are
balanced by variations of official reserves, by borrowing from
or lending to international institutions in foreign currency. The
external trade and capital movements influence the supply and
demand of foreign exchange and consequently, the prices of
currencies on the market. Generally, currencies of the countries
suffering from a deficit of current account have a tendency to
depreciate. Some thinkers consider that the BOP is a good
indicator of the pressure that a currency may be subject to. If,
over a certain period, a country buys more than what it sells
overseas, the probability of depreciation of its currency vis-a-
vis others increases. Theoretically, a country with a surplus of
BOP, all things being equal, should have a strong currency.
This adjustment of exchange rate through BOP, however, is
not always verifiable for different reasons. Firstly, all the capital
flows are not registered in the BOP account. There are always
'erro~s and 0r:'issior s' whose amount is significantly high in
certain countnes. Secondly, Forward contracts are not included
in the accounts of BOP. Besides, governments have different
EXCHANGE RATE THEORIES 33
ways of acting in short term on the equilibrium of BOP. These
include measures relating to (i) monetary and fiscal policies,
(ii) price controls, (iii) exchange control, and (iv) quantitative
and tariff barriers on imports. In any case, when the foreign
currency reserves of a country fall below the value of three
months' imports, the currency of that country is considered
vulnerable. If a country's reserves are represented by R and
annual imports plus debt service obligations by I, then N
should be greater than 3 months if the currency is not to enter
a dangerous zone. Here, N is given by the equation 3.16.
R
N = - x 12 (3.17)
I
Similarly, other factors will influence the exchange rates.
3.5 Technical Analysis: Graphical Method
for Predicting Exchange Rates
Technical analysis makes use of graphs and charts. As per tech-
nical analysts, variations of exchange rates are not random but
are linked in some way to past variations. The tendencies of
rates of the past serve to anticipate the evolution of rates in
short term. Unlike fundamental analysis, technical analysis does
not seek to determine the explanatory factors, but rather
a~tempts to understand the evolution of exchange rates from
historical series. It presupposes the stability of the behaviour
of the operators. It identifies repetitive situation and it is the
extrapolation of these tendencies which enables prediction of
future rates. Technical analysis is generally used for short-term.
3.5.1 Bar Charts of Ex~hangeRates
~ shown in the Figure 3.1, bar charts indicate for each period
(be fo.l\~wing: (a) maximum rate of the day (or of the week),
r ) ~Inlmum rate of the day (or of the week) and (c) closing
hate Indicated by a small horizontal line. Bar charts give a first
and idea of the exchange rate volatility.
34 FOREIGN EXCHANGE MARKETS
EXCHANGE RATE THEORIES 35
Rs/$

Rs41

Rs 40

Rs 39

Rs 38

4---~--'---'----.---.---r---r--~--~--~_~Days
~--------------------------~------------~T~
2 3 4 5 6 7 8 9 10 FIG. 3.3 Line of Support
FIG. 3.1 Bar Chart of Exchange Rates

3.5.2 Principal Tendencies

Principal tendencies can be determined by drawing a line that !

joins high points or low points. By joining high points, one ob- ~
tains the line of resistance. The line obtained by joining low ca
points is called the line of support. The two lines joining low ~
and high points may form a tunnel which indicates that mar-
kets are either strongly ascendent or descendent. Figures 3.2,
3.3 and 3.4 are charts of tendency.

------------------------------------------~·T~
FIG. 3.4 An Ascending Tunnel

When exchange rates differ substantially from these lines,

there is likely to be a change in the market behaviour. A rate
crossing the upper line (or line of resistance) gives a signal for
buying. Inversely, a rate crossing the lower line (or line of sup-
pqrt) gives a signal for selling.

3.5.3 Point and Figure Chart

L-__ ~------------------------------------~T~ In this chart, the time coordinate is not important. Instead,
FIG. 3.2 Line of Resistance
One defines a minimum variation, for example, 10 paise
36 FOREIGN EXCHANGE MARKETS EXCHANGE RATE THEORlE~; 37

(or 0.10 rupee). When the rate increases at least by this mini.
mum amount, a cross (x) is marked. If the rate continues to go
up, another cross is marked over the previous one in the same
column. If, on the other hand, there is a decrease in the rate,
the column is changed and a circle is marked at the new level
attained. For as long as the rate decreases, circles are marked,
each below the previous one in the same column. The highest
points of each column of crosses indicate the 'high' points.
Likewise, the lowest points of each column of circles indicate
the 'low' points. Figure 3.5 plots crosses and circles.
referred to as neck line. Normally, the volumes are high
when left shoulder is being formed. Volumes are lower
for the head and still lower for the right shoulder.
Once the neck line is crossed downward, the declining
tendency has set in. There are also inverted heads and
shoul~ers i.ndicating that a tendency of climb is going
to set m. FIgure 3.6 depicts heads and shoulders.

x x
x x x 0 x
o x x 0 x x x 0 x 0 x
~.
!II o x x 0 x 0 x x 0 x 0 x 0 x 0 x
0::
CI)
C)
C
!II
o x 0 x 0 x 0 x 0 x x 0 x 0 x 0 x 0 x ~------------------------------~--~-----.Time
s: o x 0 x 0 x 0 x 0 x 0 x 0 x 0 x 0 0 FIG. 3.6 Heads and Shoulder-s
~
W
o o x 0 x 0 x 0 o x 0 o x
(b) Wor M Forms: As· shown in Figures 3.7(a) and 3.7(b),
o o x 0 o x o
a figure, approximately similar to W or M is also
o o observed. The figure W indicates three peaks, almost
of the same level. On the other hand, M indicates a
form with two peaks and one trough.
FIG. 3.5 Point and' FiguTeChart

3.5.4 Some ObserPed Figures

.!
Some of the important figures that are observed in practice are ~
now shown. t
s
(a) Heads and Shoulders: It is a symmetrical formation with ~
two low peaks (shoulders) enclosing one high peak
(head). In a market, rates move towards high in the
form of left shoulder and then a high point is reached,
like head, often followed by a decrease, forming right --------------------------------~----~.
FIG. 3.7(a) 'w' Form
Time
shoulder. The base of the shoulders and head can be
38 FOREIGN EXCHANGE MARKETS EXCHANGE RATE THEORIES 39

(d) Diamond: This form looks like a diamond, as shown in

Figure 3.9.
l!l
fl
Q)
01
C
10
s:
o
x
LU

L-------------------------------------------~T~
FlG.3.7(b) 'M' Form

(c) Triangles: There may occur different forms of tenden L- ~Time

cies such as ascending triangle, descending triangle 0:
FlG.3.9 Diamond Form
symmetrical triangle as shown in the Figure 3.8.
(e) Flag: As shown in Figure 3. I0, there are flag forms as
well. Flags may be of climbing tendency as well as of
s10 Q) descending tendency.
a:: 1ii
Q)
a::
Q)
01
C 01
10 C
s: 10
o s:
x o Q)
LU x 1ii
LU a::
Q)
01
C
L- Time 10
s:
~----------------~Time o
x
LU
FIG. 3.8 (a) Ascending Triangle (b) Descending Triangle

~----------------~Time ~----------------~Time
FIG.3.10 (a) Ascending Flag (b) Descending Flag
l!l
10
a:: 3.5.5 Moving Averages
Q)
01
C
10
s:
o
x
Moving averages are used to follow the average tendency of
W
markets. These are generally calculated for duration of 10 and
1.- Time
3.0 days. Moving averages permit an extrapolation of the evolu-
tIon of tendency over long-term. A signal of purchase is given
FIG. 3.8 (c) Symmetrical Triangle when the curve of the exchange rate crosses upwards the curve
40 FOREIGN EXCHANGE MARKETS
EXCHANGE RATE THEORIES 41

of moving averages. Likewise, the signal of sale is given when the change market use a whole lot of information from sources
curve of exchange rate crosses downwards the curve of moving e~ch as newspapers, journals, Reuters and Telerate screens,
averages. ~adiO'television, etc. In the final analysis, though, the predic-
tion of future exchange rates is more of an art than a science.
3.6 Conclusion

A financial market is said to be efficient if the price of financial

assets reflects all available information at any given moment.
That is to say, an efficient market is the one where exchange
rates adjust themselves rapidly to the arrival of new informa-
tion and integrate it with all the past information. If currency
markets are efficient, Forward rates may be considered as unbi-
ased predictors of Future spot rates.
On the other hand, a market is said to be inefficient if cur-
rent exchange rates do not reflect all the available information.
The exponents of the theory of efficient markets say that there
is no correlation between past and present, and exchange rates
follow an uncertain path. If this was true, it would not be pos-
sible to predict future rates.
Various theories combined together explain the relationship
between different exchange rates, as there exists a strong rela-
tionship between Spot rate, Inflation rate, Interest rate and
Forward rate. The difference between Forward and Spot rate,
premium or discount, should be equal to the difference of
interest rates, which, in turn, should reflect the difference of
anticipated inflation. Anticipated difference of inflation
reflects the difference of anticipated future rates. The forma-
tion of exchange rates in real life, however, is influenced by
numerous other factors such as declaration of Presidents, Prime
Ministers, Finance ministers, results of elections and market
psychology.
In the long term, the theory of Purchasing Power Parity is
almost verified, specially for the countries whose currency is
not used for international reserves. In short term, it is the
interest differential and technical analysis that provide better
:esults. The importance of graphical or technical analysis lies
1~ Carrying out the analysis rapidly and economising on the
t.irne needed for research on fundamentals. The operators on
4 SPOT EXCHANGE MARKET

4.1 Introduction

Spot transactions in the foreign exchange market are increasing

in volume. These transactions are primarily in forms of buying/
selling of currency notes, encashment of travellers' cheques and
transfers through banking channels. The last category accounts
for the majority of transactions. It is estimated that about 90
per cent of spot transactions are carried out exclusively for
banks. The rest are meant for covering the orders of the clients
of banks, which are essentially enterprises.
The Spot market is the one in which the exchange of curren-
cies takes place within 48 hours. This market functions con-
tinuously, round the clock. Thus, a spot transaction effected on
Monday will be settled by Wednesday, provided there is no
holiday between Monday and Wednesday As a matter of fact,
certain length of time is necessary for completing the orders of
~ayrnent and accounting operations due to time differences
etween different time zones across the globe.

4.2 Magnitude of Spot Market

Accord·
rn Ing to a Bank of International Settlements (BIS) esti-
ate, the daily volume of spot exchange transactions is about
46 FOREIGN EXCHANGE MARKETS
50 per cent of the total transactions of exchange markets.
London market is the first market of the world not only in
,terms of the volume but also in terms of diversity of currencies
traded. While London market trades a large number of curren-
cies, the New York market trades, by and large, Dollar (75 per
cent of the total), Deutschmark, Yen, Pound Sterling and Swiss
Franc only. Amongst the recent changes observed on the
exchange markets, it is noted that there is a relative decline
in operations involving dollar while there is an increase in the
operations involving Deutschmark. Besides, deregulation of
markets has accelerated the process of international transac-
tions.
4.3 Participants on the Spot Market
Major participants on the spot exchange market are:
(1) Commercial banks,
(2) Dealers, brokers, arbitrageurs and speculators, and
(3) Central banks.
4.3.1 Commercial Banks
Commercial banks intervene in the spot market through their
foreign exchange dealers either for their own account or for
their clients. The banks are intermediaries between seekers and
suppliers of currency. The role of banks is to enable their cli-
ents to change one currency into another. Also, they operate on
these markets to make a profit through speculation and the
process of arbitrage. Big commercial banks serve as market-
makers. They simultaneously quote, bid and ask prices, indicat-
ing their willingness to buy and sell foreign currencies at quoted
rates. The purchases and sales of large commercial banks sel-
dom match, leading to large variation in their holdings of for-
eign currencies exposing them to exchange risk. When they
assume the risk deliberately, they act as speculators. However,
banks prefer to keep their exposure low and not get intO
unduly large speculations.
SPOT EXCHANGE MARKeT 47
4.3.2· Dealers, Brokers, Arbitrageurs and Speculators
Dealers are basically involved in buying currencies when they
are low and selling them when they are high. Dealers' opera-
tions are wholesale and majority of their transactions are
interbank in nature although, once in a while, they may deal
with corp orates and central banks. They have low transaction
costs as well as thin spreads which reflect their long experience
in exchange risk management as well as the intense competi-
tion among banks. Wholesale transactions account for 90 per
cent of the total value of foreign exchange deals. Dealers at the
retail level cater to needs of customers wishing to buy or sell
foreign exchange. The spread is wide in these transactions.
Exchange brokers specialize in playing the role of intermedi-
aries between different banks. They are ,not very large in
number. For example, at the Paris exchange market, there are
about 20 brokers. They are not authorized to take a position
on the market. Their job is to find a buyer and a seller for
the same amount for the given currencies. Their remuneration
is in the form of brokerage. They are constantly in liaison
with banks and in search of counterparties. A large portion of
foreign exchange transactions is conducted through brokers.
While they tend to specialize in certain currencies, they
virtually handle all major currencies. Brokers exist because
they lower the dealers' costs, reduce their risks and provide
anonymity. In interbank trade, brokers charge a small commis-
sion of around 0.01 per cent of the transaction amount. In
illiquid currency dealings, they charge higher commissions.
Payment of commission is split between trading parties. Banks
are able to avoid undesirable positions with the help of
brokers.
Arbitrageurs make gains by discovering price discrepancies
that allow them to buy cheap .and sell dear. Their operations
are risk-free. In a free and open market, the scope for currency
arbitrage tends to be low and it is, by and large, accessible only
to dealer banks.
S Unlike arbitrageurs, speculators expose themselves to risk.
peculation gives rise to financial transactions that develop
48 FCREIGN EXCHANGE MARKETS
when an individual's expectations differ from the expectations
of the market. Speculators transact in foreign exchange prima-
rily because of an anticipated but uncertain gain as a result of
an exchange rate change. An open position denominated in
foreign currency constitutes speculation. Banks or corp orates ,
when they accept either a net asset or a net liability in foreign
currency, are indulging in speculation.
Speculators are classified as bulls and bears. A bull expects
a currency to become more expensive in the future. He buys
the currency either Spot or Forward today in the belief that
he can sell it at a higher price in the future. Bulls take a long
position in the particular currency. A bear expects a particular
currency to become cheaper in the future. He sells either Spot
or Forward today in the hope of buying it back at a cheaper
rate in the future. Bears take a short position on a particular
currency.
4.3.3. Central Banks
Central banks intervene in the market to reduce fluctuations
of the domestic currency and to ensure an exchange rate com-
patible with the requirements of the national economy. Their
objective is not to make profit out of these interventions but to
influence the value of national currency in the interest of coun-
try's economic well being. For example, if rupee shows signs of
depreciating, central bank may release (sell) a certain amount
of foreign currency. This increased supply of foreign currency
will halt the depreciation of rupee. The reverse operation may
be done to stop rupee from appreciation.
4.4 Quotations on Spot Exchange Market
The exchange rate is the price of one currency expressed in
another currency. Each quotation, naturally, involves two cur-
rencies. There is always one rate for .buying (bid rate) and
another for selling (ask or offered rate) for a currency. Unlike
the markets of other commodities, this is a unique feature of
exchange markets. The bid rate is the rate at which the quoting
SPOT EXCHANGE MARKET 49
bank is ready to buy a currency. Selling rate is the rate at which
it is ready to sell a currency. The bank is a market-maker. It
should be noted that when the bank sells dollars against
rupees, one can say that it buys rupees against dollars. In order
to separate buying and selling rates, a small dash or an oblique
line is drawn between the two. Often, only two or four digits
are written after the dash indicating a fractional amount by
which the selling rate is different from buying rate. For exam-
ple, if dollar is quoted as Rs 42.3004-3120, it means that the
bank is ready to buy dollar at Rs 42.3004 and ready to sell dol-
lar at Rs 42.3120. Dealers do not quote the entire figure. They
may quote, for example, 3004-3120 for dollar. It is these four
digits that vary the most during the day. Here, the operators
understand because of their experience that a quote of 3004-
3120 means Rs 42.3004-42.3120.
The banks buy at a rate lower than that at which they sell a
currency. The difference between the two constitutes the profit
made by the bank. When an enterprise or client wants to buy a
currency from the bank, it buys at the selling rate of the bank.
Likewise, when the enterprise wants to sell a currency to the
bank, it sells at the buying rate of the bank. Table 4.1 gives
typical quotations. As is clear from the rates in the table, the
buying rate is lower than selling rate.
TABLE4.1 Currency Quotations given by a Bank
Currency Buying rate Selling rate
Rupee/US dollar 42.3004 42.3120
Rupee/DM 22.2025 22.2080
. The prices, as we see quoted in the newspapers, are for the
Interbank market involving trade among dealers. These rates
may be direct or European. The direct quote or European type
ta~es the value of the foreign currency as one unit. In India
It i is q~ote d as so many rupees per urut..' of foreign currency.
Pnce
S a dIrect quote or European quote. If we say forty-two
rUPee
s are needed to buy one dollar, it is an example of direct
. 50 FOREIGN EXCHANGE MARKETS
SPOT EXCHANGE MARKET 51
quote. There are a few countries which follow the system of
The spread is generally expressed in percentage by the equa-
indirect quote or American quote. This way of quoting is
prevalent, mainly, in the UK, Ireland and South Africa. In tion:
UK, for example, the quote would be one unit of pound ster-
Selling rate - Buying rate
ling equal to seventy rupees. This is indirect or American type
Spread = x 100 (4.1 )
of quote. Buying rate
Examples of direct quotes in India are Rs 42 per dollar, Rs 22
per DM and Rs 7 per French franc, etc. Similarly, the examples For example, if the quotation for dollar is Rs 42.300413120,
of direct quote in USA are $ 1.6 per pound, $ 0.67 per DM and the spread is given by
$ 0.2 per French franc, etc. One can easily transform a direct
quote into an indirect quote and vice versa. For example, a 42.3120 - 42.3004
rupee-dollar direct quote of Rs 42.3004-42.3120 can be trans- = -------- x 100 or 0.0274 per cent
42.3004
formed into indirect quote as $ 1/(42.3120)-1/(42.3004) (or
$ 0.02363-0.02364). It is important to note that selling rate is
Currencies which are least quoted have wider spread than
always higher than buying rate.
others. Similarly, currencies with greater volatility have higher
Financial newspapers daily publish the rates of different
spread and vice-versa.
currencies as quoted at a certain point of time during the day.
The average amount of transactions on spot market is about
financial Times, for example, indicates closing mid-point (mid-
5 million dollars or equivalent in other currencies.
dle of buying and selling rate), change on the day, bid-offer
. Banks do not charge commission on their currency transac-
spread and the day's high and low mid-point. Table 4.2 gives a
tiO~S but rather profit from the spread between buying and
typical quotation. These quotations relate to transactions
s~llmg rates. Spreads are very narrow between leading curren-
which have taken place on the interbank markets and are of
cies because of the large volume of transactions. Width of
the order of millions of dollars. These rates are not the ones
spread depends on transaction costs and risks, which in turn
used for enterprises or clients. The rates for the latter will be
are influenced by the size and frequency of transactions. Size
close to the ones quoted for interbank transactions. The varia-
affects the transaction costs per unit of currency traded while
tion from interbank rates will depend on the magnitude of the
freque~cy ?r turnover rate affects both costs and risks by
transaction entered into by the enterprise.
spreadmg fixed costs of currency trading.
Traders in the major banks that deal in two-way prices, for
In the interbank market, spreads depend upon the depth of
both buying and selling, are called market-makers. They create
a m~rket of a particular currency as well as its volatility. Cur-
the market by quoting bid and ask prices.
rencies with greater volatility and higher trade have larger
The Wall Street Journal gives quotations for selling rates on
spreads. Spreads may also widen during financial and eco-
the interbank market for a minimum sum of 1 million dollars no rruc. uncertainty. It may be noted that spreads charged from
at 3 p.m.
CUstomersare bigger than interbank spreads.
The difference between buying and selling rate is called
. It would be interesting to know how a typical spot operation
spread. The spread varies depending on market conditions and
IS.to be carried out. For example, an importer needs to buy $ 1
the currency concerned. When market is highly liquid, the
:Il~~n to pay to his American supplier. The importer calls
spread has a tendency to diminish and vice versa.
tl IS bank and asks for a rate of US dollar. After receiving
e rate from the bank, the importer indicates his account to
52 FOREIGN EXCHANGE MARKETS SPOT EXCHANGE MARKET 53

TABLE 4.2 A Typical Sample of Quotations of Currencies Philippines (Peso) 37.8550 +0.0500 37.9500 37.7600
(against US dollar) in Financial Newspapers Saudi Arabia (SR) 3.7506 3.7507 3.7504
Singapore (S$) 1.7018 -0.0010 1.7040 1.6992
June 24 Closing Change Day's mid South Africa (R) 6.0630 +0.0413 6.0695 6.0237
mid-point on day South Korea (Won) 1157.50 -5.0000 1162.50 1157.00
High Low Taiwan (T$) 32.3750 +0.0050 32.3800 32.3600
Thailand (Bt) 36.6500 -0.0500 36.7200 36.6000
Europe -------------------------------------------------
Austria (Sch) 13.3001 -0.0452 13.3466 13.2757 Source: Financial Times, 25 June 1999.
Belgium (BFr) 38.9909 -0.1323 39.1270 38.9190
Denmark (DKr) 7.1862 -0.0213 7.2090 7.1710 the bank and asks it to debit his account in rupees in Delhi
Finland (FM) 5.7469 -0.0195 5.7670 5.7364 and credit the account of the American supplier in dollars in
France (FFr) 6.3402 -0.0216 6.3623 6.3286
America. A majority of exchange operations takes place
Germany (DM) 1.8905 -0.0064 1.8970 1.8870
Greece (Dr) 313.630 -1.7200 314.630 312.750 through transfer from one account in one bank to another
Ireland (1£) 1.3137 +0.0044 1.3161 1.3091 account in another bank.
Italy (L) 1871.52 -6.3500 1878.05 1868.08
Luxembourg (LFr) 38.9909 -0.1323 39.1270 38.9190 4.5 Evolution of Spot Rates
Netherlands (FI) 2.1300 -0.0073 2.1374 2.1261
Norway (NKr) 7.8500 -0.0030 7.8890 7.8073 How does one calculate the change in spot rate from one quo-
Portugal (Es) 193.777 -0.6580 194.450 193.420 tation to the next? In case of direct quotation, it is given by the
Spain (Pta) 160.822 -0.5460 161.380 160.530 equation:
Sweden (SKI) 8.4539 +0.0219 8.4693 8.3997
Switzerland (SFr) 1.5443 -0.0038 1.5494 1.5417
UK (£) 1.5812 +0.0039 1.5818 1.5741 Change in percentage =
Euro (Eu) 1.0346 +0.0035 1.0370 1.0307 Rate N - Rate (N - 1)
SDR 0.74930 x 100 percent (4.2)
Rate (N - 1)
America
Argentina (Peso) 0.9999 0.9999 0.9999 For example, the dollar rate has changed from Rs 42.50 to
Brazil (R$) 1.8050 +0.0210 1.8060 1.7920 Rs 42.85, the change is calculated to be
Canada (C$) 1.4725 -0.0020 1.4730 1.4687
Mexico (New Peso) 9.4500 +0.0450 9.4550 9.4450
42.85 - 42.50
USA ($)
x 100 per cent or 0.909per cent
Pacific/Middle East/Africa 42.50

Australia (A$) 1.5213 -0.0029 1.5223 1.5163

Ch;imil.arI~, if the quotation is in indirect form, the percentage
Hong Kong (HK$) 7.7578 7.7583 7.7573 nge IS given by equation:
India (Rs) 43.3275 +0.0675 43.3370 43.3070
Indonesia (Rupiah) 6755.00 +40.000 6780.00 6680.00
Israel (Shk) 4.1 176 +0.0012 4.1225 4.1108
Change in percentage =
Japan (¥) 122.245 +0.2800 122.300 121.650 Rate (N - 1) - Rate N
Malaysia (M$) 3.8000 3.8001 3.8000 x 100 per cent (4.3)
New Zealand (NZ$) 1.8641 -0.0133 1.8706 1.8615 Rate N
54 FOREIGN EXCHANGE MARKETS

For example, the above rate has passed from 1/42.50 to OOO"\COC'lO"\O"\C'lCO~"'"
C'l'DO"\ •...•
C'lC'lC'lr--C'lr--
1/42.85 so the decrease in the rupee is ~~g;~~g8~~
C"1<'i\Ci<'io<'ioo<'i<'i

(ds-o - i.s-s) C'lC'lr--~r--~cor--C'l

~ 00 co co CV) r-, 0 0 r-,
.......otM~C'J~.....-40......c,......j
~COC"1O"\C'looOOCO
"";o<'ioooooo
0
I lrl
00
C"1
0
x 100
1
42.85

or
0.02597 - 0.02574
x 100 per cent or 0.89 per cent \

0.02574 ......c~C'f")......c
lrlCO'DQ\r--r--
C'l~O~C"1CV) 0\......c0\......c

Nominal exchange rates may appreciate or depreciate but cxi<'ir--:....;""r--: <'ir--:r--:v-i

O •...•
C"1C'lO"\CO •...•
COO'D
r--O co •...•
C'l 0"\ Q\C'l~
that does not reflect upon the competitiveness of the country ......c......ce""l........c ....•
in the international markets. For that purpose, the real
exchange rate needs to be calculated by taking a particular year
as base year.
The real exchange rate is the rate obtained by taking into 00
Q\
account the change in prices (or the rate of inflation) in \the 0"\

two countries during the period under consideration. If a cur-

C'l00 r-, lrl~o"\lrlC'l •...•
r--
rency has appreciated in nominal terms more than what is jus- C"1C'lQ\ C'loo •...•
or--~
C'lOC'l 'Dcoo •...•
cor-- •...•
tified by the inflation rates of the two countries, it is said that lrlQ\lrl C'looOOCOO~
"";o<'i 00000"";0
the rate is over valued. An increase in the real exchange rate
•...•
Q\ CV)COO~lrlQ\COQ\
represents an increase in purchasing power. On the other hand, 8'D IlrlC"1coo~r--lrlC"1
a decrease in the real exchange rate represents a decrease in 'D~ ~S~gg~~~
00 00000000
purchasing power. C'l •...•
r--r--C'lor--oo~
A variation of nominal rates does not automatically alter the r-, I C'lr-,0 lrl•...•
00 oOQ\r--o
C'llrlC"1Q\
•...•
r--Q\lrl
'D CO •...•
C'lQ\oOQ\ •...•
~
competitive positions of enterprises, if the rates of inflation of ....; <'i"";ooooo"";o
the countries concerned compensate the variation. In contrast,
a variation of real exchange rate has an important impact on
competitive positions. The knowledge and analysis of real ex-
change rates and their evolutions is important for the political
economy of a country.

4.6 Cross Rates

We will take an example to explain the concept of cross rates·

56 FOREIGN EXCHANGE MARKETS
SPOT EXCHANGE MARKET 57
Let us sayan Indian importer is to settle his bill in Canadian
dollars. His operation involves buying of Canadian dollars (B/C)bid = (B/A)bid X (NC)bid (4.4)
against rupees. In order to give him a Can $IRe rate, the banks (B/C).sk = (B/A)askx (NC)ask (4.5)
should call for US $/Can $ and US $/Re quotes. That~e ns Here
that the bank is going to buy Canadian dollars against eri,
(B/A)bid = (NB).sk
can dollars and sell those Canadian dollars to the imp rter
against rupees. Suppose the rates are and
(B/A)ask= (NB)bid
Can $NS $: 1.3333-63
RupeeNS $: 42.3004-3120 f.xIDnple 4.1: Following rates are given:
Rs 221DM and Rs 6.60/FFr.
Finally. the importer will get the Canadian dollars at the fol-
What is FFr/DM rate?
lowing rate:
StOtion: It is clear from the data that bid and ask rates are
42.3120 equal. Cross rate will give the relationship between FFr and
Rupee/Can $ = = Rs 31. 7348/Can $ OM:
1.3333
Rs22 1 FFr 22 FFr 22
That is, importer buys US $ (or bank sells US $) at the rate --x ~_- = --- = FFr 3.3333/DM
OM Rs 6.60 DM 6.60 DM 6.60
of Rs 42.3120 per US $ and then buys Can $ at the buying
rate of Can $ 1.3333 per US $. FFr
So Rupee 31.7348/Can $ is a cross rate as it has been
Eumple 4.2: From the following rates, find out Re/DM relation-
derived from the rates already given as Rupee/l.IS $ and Can $/ ship:
US $. So cross. rate can be defined as a rate between a third
pair of currencies, by using the rates of two pairs, in which one R.e!Us $: 42.1000/3650
currency is common. It is basically a derived rate. OMlUS$: 1.5020/5100
Likewise, the buying rate would be obtained as Rs 31.43.041
Can $ Sobttion: Applying the equations (4.4) and (4.5), we get

(Re/DM)bid = (ReNS $)bid x (US $/DM)bid

or 42.0004 ) = 42.1000 x 1/( 1.51 00)
( = 27.8808
1.3363

(ReJDM).sk = (ReNS $)'Sk x (US $/DM).sk

Table 4.3 contains cross rates between different pairs of cur- = 42.3650 x 1/( 1.5020)
rencies.
= 28.2057
In general, the equations 4.4 and 4.5 can be used to find
the cross rates between two currencies Band C, if the ratef So, the Re/DM relationship is
between A and B and between A and C are given:
27.8808-28.2057
58 FOREIGN EXCHANGE MARKETS SPOT EXCHANGE MARKET 59

4.7 Equilibrium on Spot Markets ThUS, in the process, he will make a gain of
Rs 10,00,000
In inter-bank operations, the dealers indicate a buying rate and x (42.7650) - Rs 10,00,000
a selling rate without knowing whether the counterparty wants 42.7610
to buy or sell currencies. That is why it is important to give or
'good' quotations. When differences exist between the SPOt Rs 93.50
rates of two banks, the arbitrageurs may proceed to make
arbitrage gains without any risk. Arbitrage enables the re-estab. Though the gain made on Rs 10,00,000 is apparently small,
lishment of equilibrium on the exchange markets. However, as if the sum involved was in couple of million of rupees, the gain
new demands and new offers come on the market, this equilib. would be substantial and without risk.
rium is disturbed constantly. It is to. be ~oted th.at there will be no geographical arbitrage
On the Spot exchange market, two types of arbitrages are gain possible If there IS an overlap between the rates quoted at
possible: two di~ferent dealers. For example, consider the following two
quotatIons:
(1) Geographical arbitrage, and
Dealer A: Rs 42.7530-7610
(2) Triangular arbitrage. Dealer B: Rs 42.7600-7700

4.7.1 Geographical Arbitrage 42.7530 I 42.7610

Geographical arbitrage consists of buying a currency where it is 42.7600 42.7700

the cheapest, and selling it where it is the dearest so as to make
a profit from the difference in the rates. In order to make an Since there is an overlap between the rates of dealers A and
arbitrage gain, the selling rate of one bank needs to be lower B respectively, no arbitrage gain is possible, unlike in the exam-
ple 4.3.
than the buying rate of the other bank. Example 4.3 explains
how geographical arbitrage gain is made.
4.7.2 Triangular Arbitrage
Example 4.3: Two banks are quoting the following US dollar
rates: Tri~ngular arbitrage occurs when three currencies are involved.
thIS can be realised when there is distortion between cross rates
of cur rencres,
. Examp Ie 4.4 Illustrates
. the triangular arbitrage.
Bank A: Rs 42.7530-7610
Bank B: Rs 42.7650-7730 Example 4.4: Following rates are quoted by three different
dealers:
Find out the arbitrage possibilities.
£IUS s. 0.6700 Dealer A
FFr/£: 8.9200 Dealer B
Solution: An arbitrageur who has Rs 10,00,000 (let us suppose)
will huy dollars from the Bank A at a rate of Rs 42.7610/$ and
FFr/US s. 6.1080 Dealer C
sell the same dollars at the Bank B at a rate of Rs 42.7650/$· Are there any arbitrage gains possible?
60 FOREIGN EXCHANGE MARKETS

Solution:Cross rate between French franc and US dollar is

0.6700 x 8.9200 or FFr 5.97641US $. Compare this with the
given rate of FFr 6.1080/US $. Since there is a difference
between the two FFr/$ rates, there is a possibility of arbitrage
gain. The following steps have to be taken:

(i) Start with US $ 1,00,000 and acquire with these dol-

lars a sumofFFr 6,10,800 (1,00,000 x 6.1080)
(ii) Convert these French francs into Pound sterling, to
get £ 68475.34 (6,10,800/8.92)
5 FORWARD EXCHANGE MARKET
(Hi) Further convert these Pound sterling into US dollar,
to obtain $ 1,02,202 (68,475.3410.67).

Thus, there is a net gain of US $ 2,202. Of course, the real

gain will be less, as we have not taken into account the transac-
tion costs here.
The arbitrage operations on the market continue to take place
as long as there are significant differences between quoted and
cross rates. These arbitrages lead to the re-establishment of the
equilibrium on currency markets.
4.8 Conclusion
The Spot exchange market is very important. But its rate of
growth is less than that of derivative products. The major part
of Spot transactions are done between different dealers. The
rest of the transactions are done for different clients or enter-
prises. The markets are rarely in equilibrium. Once art equilib-
rium is established through arbitrage process, it does not
remain in existence for long. New demands and offers create
new conditions for arbitrage. The arbitrageurs try to make
gains through geographical as well as triangular arbitrage.
S.l Introduction
Like the Spot exchange market, the Forward exchange market
is not located at any specific place. The banks selling or buying
currencies forward constitute the Forward market. This market
fixes the rates at which currencies will be exchanged on a future
date. The Forward market primarily deals in currencies that are
frequently used and are in demand in the international trade,
such as US dollar, Pound Sterling, Deutschmark, French franc,
Swiss franc, Belgian franc, Dutch Guilder, Italian lira, Cana-
dian dollar and Japanese yen. There is little or almost no For-
ward market for the currencies of developing countries. For-
Ward rates are quoted with reference to Spot rates as they are
always traded at a premium or discount vis-a-vis Spot rate in
the inter-bank market. The bid-ask spread increases with the
forward time horizon. Some of the Significant features of For-
Ward contracts are given in Table 5.1.

S.2 Importance of Forward Markets

The Forward market can be divided into two parts-Outright

Porward and Swap market. The Outright Forward market
resembles the Spot market, with the difference that the period
62 FOREIGN EXCHANGE MARKETS FORWARD EXCHANGE MARKET 63

of delivery is much greater than 48 hours in the Forward mar- exchange rates. Speculators take risk in the hope of making a
ket. A major part of its operations is for clients or enterprises gain in case their anticipation regarding the movement of rates
who decide to cover against exchange risks emanating from turns out to be correct. As regards brokers, their job involves
trade operations. match making between seekers and suppliers of currencies on
The Forward Swap market comes second in importance to the Spot market. Hedgers are the enterprises or the financial
the Spot market and it is growing very fast. The currency swap institutions who want to cover themselves against the exchange
consists of two separate operations of borrowing and of lend- risk.
ing. That is, a Swap deal involves borrowing a sum in one cur-
rency for short duration and lending an equivalent amount in S.3 Quotations on Forward Markets
another currency for the same duration. US dollar occupies an
important place on the Swap market. It is involved in 95 per Forward rates are quoted for different maturities such as one
cent of transactions. month, two months, three months, six months and one year.
Usually, the maturity dates are closer to month-ends. Apart
TABLE 5.1 Significant Features of Forward Contract from the standardised pattern of maturity periods, banks may
quote different maturity spans, to cater to the market/client
Features Description
needs.
1. Kind of A private contract between a customer and a dealer, The quotations may be given either in outright manner or
contract with flexible terms. through Swap points. Outright rates indicate complete figures
2. Currencies Forward contracts are available in all major currencies for buying and selling. For example, Table 5.2 contains Re/FFr
of the world, including several of developing coun- quotations in the outright form. This kind of rates are quoted
tries as well. to the clients of banks.
3. Cashflows Cashflows occur only at the time of maturity/delivery.
A majority (more than 90 per cent) of contracts are TABLE 5.2 Re/FFr Quotations
settled by delivery.
Buying rate Selling rate Spread
4. Quotations Prices are quoted by dealers with bid-ask spreads. The
rates are locked in for the entire period of contract Spot 6.0025 6.0080 55 points
up to maturity.
One-month forward 6.0125 6.0200 75 points
5. Risk A loss can occur in case of default on either side. 3-month forward 6.0250 6.0335 85 points
6. Dealers' Commission is inbuilt in the bid-ask spread. The 6-month forward 6.0500 6.0590 90 points
commission Forward market is, by and large, self-regulated.

Major participants in the Forward market are banks,
arbitrageurs, speculators, exchange brokers and hedgers. Com-
mercial banks operate on this market through their dealers,
either to cover the orders of their clients or to place their
own cash in different currencies. Arbitrageurs look for a profit
without risk, by operating on the interest rate differences and
If the Forward rate is higher than the Spot rate, the foreign
CUrrency is said to be at Forward premium with respect to the
domestic currency (in operational terms, domestic currency is
likely to depreciate). On the other hand, if the Forward rate
is lower than Spot rate, the foreign currency is said to be at
Forward discount with respect to domestic currency (likely to
appreciate).