Question

1. How does forward exchange rate differ from spot exchange rate?
2. Suppose £ represents British pound and ¥ represents Japanese yen. If E_¥/£ = 150 in Tokyo while E_¥/£ = 155 in London. How would you do arbitrage to make a profit?
3. What is the meaning of covered interest parity? How do you use it to determine the forward exchange rate?
4. What is the meaning of uncovered interest parity? How do you use it to determine the spot exchange rate?

Answer 1

Difference in forward and spot exchange rate :

1. Meaning - SPOT as word suggests tells about the present exchange rate i.e. what rate one will get for currency however FORWARD also as it suggests it tells about the future rate of exchange for the currency
2. Dealing transactions - SPOT deals with the current transaction in foreign market however FORWARD deals with transactions which are contracted in present but will be implemented in future
3. QUOTATIONS - SPOT are given neither premium nor discount however the FORWARD are given in premium or discount
4. Reason for offers - SPOT shows the present market condition which cannot be altered as such so no need for discounts or premium however FORWARD gives such offer to make it attractive as there can be loss or profit due to change in rate
5. Nature - SPOT works on daily nature or current market however FORWARD works on future market

MAKE ARBITRAGE PROFIT:

First, arbitrage profit is when a person can take advantage of difference in the market price in different economies as a result buying from cheap economy and selling it in high priced economy helps to gain profit

Example as in TOKOYO the price of currency is 150 and in LONDON it's 155 , so buying from TOKOYO and selling in London would make the investor profit of 5 on each unit.

COVERED INTEREST PARITY AND USE IN FORWARD EXCHANGE RATE :

Meaning - The covered interest parity or CIP is a general principle in financial market so that " the difference of interest of two currency in there money market should EQUATE with the difference in the forward and spot exchange rate

Role in forward exchange rate - ​​​​​-It can be helpful to determine the forward exchange market owing to its NO ARBITRAGE CONDITION because of which a person can defend himself from the future uncertainities and risk . However parity can occur at a time and can change over time

UNCOVERED INTEREST PARITY AND SPOT EXCHANGE RATE :

Meaning - Unlike covered it basically helps to forecast rates and not insuring with the risk; it is the difference in the rate of interest of two nations at the time when it equates the relative change in foreign exchange rate

Role in spot exchange rate - as it does only forecasting so with it one cannot determine any future rate of contracts ,so we use expected spot rate only from which is prevailing in market. However to get spot rate one should that discount rate with which one can make the present value of asset equal to its price quoted

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