FORWARD RATE

AND FUTURE SPOT

RATE RELATIONSHIP

Foreign Exchange Supply and

Demand

Prices of goods, commodities

and exchange rates are
determined on open markets
under the control of two
forces, supply and demand.

The value of a nations

currency, under a floating
exchange rate, is determined
by the interaction of supply
and demand.

Demand Curve

Supply Curve

Demand and Supply of Foreign

Exchange

The demand for foreign exchange is inversely

proportional to the rise of exchange rate. As the
exchange rate goes up the demand for foreign
exchange declines.

If the supply of a countrys currency increases the

value of the currency decreases in relation to other
currencies and more money is required to buy the
foreign exchanges.

Equilibrium Exchange
Rate

The foreign
exchange market
is considered to be
in equilibrium
when the deposits
of all the
currencies provide
equal rate of
return that was
expected.

Arbitrage
Buying in one market and simultaneously selling
in another, profiting from a temporary difference.
This is considered
investor/trader.

riskless

profit

for

the

If all markets were perfectly efficient, there would

never be any arbitrage opportunities.

The Law of One Price

The theory that the price of a given

security, commodity or asset will have the
same price when exchange rates are taken
into consideration

Purchasing Power Parity (PPP)

economic theory that estimates the
An
amount of adjustment needed on the
exchange rate between countries in order
for the exchange to be equivalent to each
currency's purchasing power.
Relative PPP:

Inflation Differential

The inflation rate differential is the

difference between the inflation rate in one
country and the inflation rate in another.

Nominal and Real Exchange Rates

The nominal exchange rate simply states
how much of one currency can be traded
for a unit of another currency. The real
exchange rate, on the other hand,
describes how many of a good or service
in one country can be traded for one of that
good or service in another country

Fisher Effect
Theory

that describes the relationship

between inflation and both real and
nominal interest rates

r: Real interest rate

i: Nominal interest rate
: inflation rate

International Fisher Effect (IFE)

Exchange-rate model based on present
and future risk-free nominal interest
rates rather than pure inflation.
Used to predict and understand present
and future spot currency price movements.

Interest Rate Differential (IRD)

Measures the gap in interest rates
between two similar interestbearing assets.
Used
when
pricing
exchange rates.

forward

Real Interest Rate Parity

Condition

A theory in which the interest rate

differential between two countries is equal
to the differential between the forward
exchange rate and the spot exchange rate.

Real Interest Rate Parity

Condition

Option A

Option B

When no arbitrage opportunities exist, the

cash flows from both options are equal.

Covered Interest Rate Condition

Refers to a condition where the
relationship between interest rates and the
spot and forward currency values of two
countries are in equilibrium.

Forward Rate and Spot Rate

Relationship
Forward rate: A rate applicable to a
financial transaction that will take place in
the future.
Spot rate: The price quoted for immediate
settlement on a commodity, a security or a
currency

Forward Rate and Future Rate

Relationship

% difference
between FORWARD
and SPOT rates

Expected change in
the SPOT rate

Thank you for your

attention!