The forward exchange rates

The forward exchange market, exists for the purpose of trading in foreign exchange "future." It is not, of course, an organized, definable trading place, but rather is an adjunct of the "spot" market. In the spot market, all exchange dealt in (whether cable, demand, or time) is for immediate delivery by the seller and immediate payment by the buyer. The forward market deals in contracts for foreign exchange requiring future delivery by the seller and future payment by the buyer.

Forward Rates Contrasted with Time Rates

There has been much unnecessary confusion between the rate of exchange on time drafts and the forward rate, a confusion which has even crept into at least one recent book. In the early pages of this chapter it was explained that in any foreign exchange spotmarket time drafts--say, payable 60 days after date--almost invariably sell at a lower rate than do sight or demand drafts, principally because of the interest or discount factor. The forward rate on a given foreign exchange may be identical with that for spot cables or sight or demand exchange, may be at a discount, or may be at a premium, depending on many things.

Foreign exchange dealers in the spot market buy and sell cables and demand and time bills. In the forward market they quote rates for the delivery of demand or cable exchange to buyers at a future date and they buy time bills for future delivery. If an importer needs sterling 30 days hence, he may contract to buy sterling for delivery in 30 days--i.e., to be available to him by cable on the foreign center 30 days hence. If an exporter has a 30-day sterling draft for £1,000 which he plans to hold till maturity, he may contract to sell £1,000 for delivery in 30 days. Although he holds a time draft, he will be able to deliver demand sterling under his futures contract, because in 30 days the draft will be payable.

Determination of Forward Rates

Forward exchange rates, then, are the rates quoted on foreign exchange deliverable at a defined future time. Customarily a forward transaction is evidenced by a contract between the buyer and seller stating the quantity of exchange, the rate, and the delivery date. 1 Immediately two questions arise: How are forward rates determined and what is the extent of the forward market?

At first sight it seems self-evident that all transactions in the forward exchange market should find their direct counterparty there, and that a firm who wants to sell a forward claim in a certain currency, due let us say two months hence, has to find a firm who wants to cover forward a commercial obligation in the same currency for the same amount and per the same date. Or perhaps that there must be a speculator ready to buy this claim outright in the forward market, as a bull speculation. Now the operations in the forward market very seldom take place in this way.

The demand for forward exchange, then, comes from a number of sources such as importers, "bull" speculators, capital movements, etc. The supply of forward exchange is provided by exporters, by "bear" speculators, and by capital movements. Through the operation of these forces a future rate is regularly quoted for all currencies for which forward markets exist. These rates will vary in relation to the rate on cable or demand exchange in the spot or cash 3 market, being either at par with it, or at a premium or discount. Forward rates will be quoted only for specified time periods, 30, 60, 90, 120, and occasionally 180 days or longer, although banks normally will provide customers with forward exchange, contracts for intermediate periods within these limits.

In the forward market, just as in the spot market, rates are determined by supply and demand. Let us explore the making of forward rates more thoroughly. If forward sales of a given foreign exchange exceed forward purchases, there will be a tendency for the forward rate on that currency to go to a discount in relation to the demand rate in the spot market. Conversely, of course, a premium may emerge in the forward market. Importers' purchases and exporters' sales are only part of the demand and supply in the forward market. Usually, to be sure, they are a very large factor in forward rate making; but often speculation and arbitraging may dominate the forward market.