world of economics
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  • The most common type of foreign exchange transaction involves the payment and receipt of the foreign exchange within two business days after the day the transaction is agreed upon. The two-day period gives adequate time for the parties to send instructions to debit and credit the appropriate bank accounts at home and abroad. This type of transaction is called a spot transaction, and the exchange rate at which the transaction takes place is called the spot rate.
  • Besides spot transactions, there are forward transactions. A forward transaction involves an agreement today to buy or sell a specified amount of a foreign currency at a specified future date at a rate agreed upon today (the forward rate). For example, I could enter into an agreement today to purchase ¤100 three months from today at $1.01 = ¤1. Note that no currencies are paid out at the time the contract is signed (except for the usual 10 percent security margin). After three months, I get the ¤100 for $101, regardless of what the spot rate is at that time. The typical forward contract is for one month, three months, or six months; with three months the most common. Forward contracts for longer periods are not as common because of the great uncertainties involved. However, forward contracts can be renegotiated for one or more periods when they become due. In what follows, we will deal exclusively with three-month forward contracts and rates, but the procedure would be the same for forward contracts of different duration.
  •  The equilibrium forward rate is determined at the intersection of the market demand and supply curves of foreign exchange for future delivery. The demand for and supply of forward foreign exchange arise in the course of hedging, from foreign exchange speculation, and from covered interest arbitrage. These, as well as the close relationship between the spot rate and the forward rate. All that needs to be said here is that, at any point in time, the forward rate can be equal to, above, or below the corresponding spot rate.
  •  If the forward rate is below the present spot rate, the foreign currency is said to be at a forward discount with respect to the domestic currency. However, if the forward rate is above the present spot rate, the foreign currency is said to be at a forward premium. For example, if the spot rate is $1 = ¤1 and the three-month forward rate is $0.99 = ¤1, we say that the euro is at a three-month forward discount of 1 cent or 1 percent (or at a 4 percent forward discount per year) with respect to the dollar. On the other hand, if the spot rate is still $1 = ¤1 but the three-month forward rate is instead $1.01 = ¤1, the euro is said to be at a forward premium of 1 cent or 1 percent for three months, or 4 percent per year. Forward discounts (FD) or premiums (FP) are usually expressed as percentages per year from the corresponding spot rate and can be calculated formally with the following formula:

where FR is the forward rate and SR is the spot rate. The multiplication by 4 is to express the FD(−) or FP(+) on a yearly basis, and the multiplication by 100 is to express the FD or FP in percentages. Thus, when the spot rate of the pound is SR = $1.00 and the forward rate is FR = $0.99, we get

the same as found earlier without the formula. Similarly, if SR = $1 and FR = $1.01:

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