Question

please clearify why the forward exchange rate contract is the best predictor of exchange rate. The answer must cover pros and cons

Answer 1

Forward Exchange Rate Contract:

Forward Exchange rate contract means contract to Short/Long specified foreign currency at some specified future date but at rate agreed upon today.

Forward Exchange Rates as a Best predictor of Exchange rate (with pros and cons):

Forward Exchange rate is determined using Interest rate parity theorem i.e. difference in Interest rate between two countries to eliminate arbitrage opportunity and to shows economic equilibrium in Forex market. Forward exchange rate is useful in forecasting of Future Spot exchange rates since it is an unbiased predictor which doesn't incorporate any Forex risk premium .Forward rates are based on certain agreement which is decided by incorporating all the possible factors which could be a reason to change in Exchange rate like Interest, Inflation etc.

However there are some other factors also which is not predictable but it could be a major reason of changes in foreign exchange rates (for eg- Political factors). Since, Forward rates does not incorporate all the parameters, hence it could not be useful in all the cases to predict Future spot rate.

Note: In case of any Queries/Suggestion, feel free to ask in the comment box.