What is the difference between a spot and forward FX rate? Suppose that the spot

Question

What is the difference between a spot and forward FX rate? Suppose that the spot US Dollar price of the Canadian Dollar was $0.90 and the 180 day forward rate is $0.9180. What does the forward price relative to the spot price tell us about the predicted direction of the Canadian dollar? Is that forward rate an accurate predictor of the spot rate in 180 days? What are the spot and forward Canadian Dollar prices of the US Dollar? Please describe the two types of participants in the forward FX market.

Explanation / Answer

Spot rate oe spot Price is the the current price of Asset quoted for the immediate settlement of spot contract.It involves purchase and sale of any commodity, security, currency etc for immediate delivery and payment on the spot date which is generally 2 business days after the trading date.

Forward rate is the rate fixed (agreed) toaday but the delivery and settlement made on some specied future date.

Spot USD0.90/CAD

180Days Forward= USD0.9180/CAD

Forward rate shows the rate agreed toady for the delivery and settlement of CAD after 180 days .It also shows the time value of money and the storage cost saved. It shows the rate of CAD after 180 days will rise and to lock that unexpected rise Forward contracts are made today.

As per Pure Expectations Theory , Forward Rate is the accurate prediction of Future Spot rate. but PET is heavily criticised as we are living in risk averse world not in risk neutral world. Empeical evidence contradicts PET( long term as well as short term) and it has been noticed that investors demand liquidity premium when investing for long term.

Spot = 1/0.90= CAD 1.11/USD

180 Forward Rate= 1/0.9180= CAD1.089

Participants in forward market are Hedgers, Speculators, Traders,and Arbitgeurs.

Hedger: Hedger are participant who enters into futures and forward contact to manage (hedge)the risk of adverse fluctuation in the prices of existing or future underlying.

Arbitrageurs: Arbitrage refers to simultaneously buying and selling in two markets such that it can generates the risk less profit without making an investment. Those who enter into these contracts are called arbitageurs.

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