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Interest and Forward Rates

Differences in interest rates between different countries exert an important influence on the forward exchange rate.

Suppose that the rate of interest is three per cent in London and two per cent in India and the spot and forward exchange rates are at par. Such a situation will offer an inducement for the transfer of funds from India to London. Those who move funds from India to London will like to cover themselves against exchange risks by buying forward rupees.

The demand for forward rupees will far exceed its supply. At the same time, the spot supply of rupees will far exceed the demand for it. This will raise the forward rate and lower the spot rate of the rupee, as the funds are transferred from India to London, the discount on forward relative to spot rate will go on rising.

This will diminish the profitability of and, consequently, the inducement for the transfer of additional funds from India to London. Simultaneously, there will operate another equilibrating force. Transfer of funds from India to London will tend to raise the interest rate in India and lower the same in London and thus narrow the differences in interest rate rates between the two countries.

Decrease of the interest differential will further decrease the profitability of and hence the in1ducement for the transfer of funds from India to London. Ultimately, an equilibrium will be reached when the discount on forward exchange becomes equal to the interest differential and there will be no, inducement for the further transfer of capital.

The equilibrium may be reached either through a change in interest differential or through a variation in the discrepancy between the spot and forward exchange rates or through a combination of the two; the last possibility is likely to be the most probable one.

Speculation and forward exchange--- speculators, unlike the traders, banks and arbitragers take an open or uncovered position expecting to gain from changes in exchange rates. If a speculator expects that sterling is going to depreciate in future, he will sell forward sterling at a rate slightly higher than the expected rate. In case, he expects the sterling to be strong in future, he will buy sterling at a rate slightly lower than the expected rate.

In case the events go against his expectation, he suffers a loss. The activities of bear speculators can substantially depress the forward exchange rate of any currency, i.e., the exchange will be quoted at large discounts. Similarly, the activities of the bull speculators can substantially raise the forward exchange rate, i.e., the exchange will be quoted at large premiums.

Speculative transactions form an important part of the forward exchange market. It is doubtful if the forward exchange markets can operate only on transactions arising from trade, capital movements and arbitrage activities.

Spot and forward rates act and react upon each other. Spot rates are one of the important factors which the dealers in forward exchange keep in view while quoting forward rates.

Movements in spot rates, therefore, will affect forward rates. Normally, movements in spot rates will cause movements in forward rates in the same direction. Sometimes, however, the movement in spot rate has moved too far form its stable position, the forward rates may start moving in the reverse direction before the spot rate does so.