Chapter 4
Understanding Forward
Exchange Rates for Currency
In this chapter, we discuss forward contracts in perfect financial markets. Specif-
ically, we assume that there are no transactions costs; there are no taxes, or at
least they are non-discriminatory: there is but one overall income number, with all
capital gains and interest earned being taxable and all capital losses and interest
paid deductible; there is no default risk; and people act as price takers in free and
open markets for currency and loans or deposits. Most of the implications of mar-
ket imperfections will be discussed in later chapters; in this chapter we provide the
fundamental insights that need to be mildly qualified later.
In Section 1, we describe the characteristics of a forward contract and how forward
rates are quoted in the market. In Section 2, we show, with a simple diagram,
the relationship between the money markets, spot markets, and forward markets.
Using the mechanisms that enforce the Law of One Price, Section 3 then presents
the Covered Interest Parity Theorem. Two ostensibly unconnected issues are dealt
with in Section 4: how do we determine the market value of an outstanding forward
contract, and how does the forward price relate to the expected future spot price.
We wrap up in Section 5.
4.1 Introduction to Forward Contracts
Basics
Let us recall, from the first chapter, the definition of a forward contract. Like a spot
transaction, a forward contract stipulates how many units of foreign currency are
to be bought or sold and at what exchange rate. The difference with a spot deal, of
course, is that delivery and payment for a forward contract take place in the future
(for example, one month from now) rather than one or two working days from now,