Spot and Forward Foreign Exchange Rates

There are two types of foreign exchange rates, namely the spot rate and forward rates ruling in the foreign exchange market. The spot rate of exchange refers to the rate or price in terms of home currency payable for spot delivery of a specified type of foreign exchange. The forward rate of exchange refers to the price at which a transaction will be consummated at some specified time in future.

In modern times the system of forward rate of foreign exchange has assumed great importance in affecting the international capital movements and foreign exchange banks play an important role in this respect by matching the purchases and sales of forward exchange on the part of would be importers and would be exporters respectively. The system of forward foreign exchange rate has actually been developed to minimize risks resulting from the possibility of fluctuations over time in the spot exchange rate to the importers and exporters. An example would illustrate this point. Suppose that a tablet pc dealer in India wants to import tablet pc’s and mobile tablet’s from England. The foreign exchange rate at the moment is Rs.18 for a pound sterling and at this rate the Indian tablet pc dealer calculates that he could import the tablet pc’s, pay the customs duty on them, sell them in India, pay the sterling price of the tablet pc’s and make a profit on them. But by the time the tablet pc’s have been shipped across the ocean, exhibited in Mumbai, sold and paid for, several months will have elapsed and the foreign exchange rate may now be Rs. 20 for a pond-sterling in which case he has to pay Rs. 2 more for each pound sterling of the price of the tablet  and in place of expected profits he may realize actual losses. In other words, the transaction will be profitable only if the Indian exporter can import tablet’s at an exchange rate of 18 rupees for a pound sterling.

The forward foreign exchange rate market gives him this assurance. His band will sell him “three months forward” pound-sterling at Rs. 18 per pound sterling by charging a slight premium. That means that the bank undertakes to sell the named quantity of the pound–sterling at and exchange rate of Rs. 18 per pound–sterling in three months time, whatever the rate of exchange in the exchange market may be when that time comes. Similarly, persons who expect to receive sums in foreign currency at future dates are able to sell “forward exchange” to the banks in order to be sure in advance exactly how much they will receive in terms of home currency. The basic importance of forward rate of exchange flows from the fact that actual rate of exchange is liable to fluctuate from time to time and this renders the purchase and sale of goods abroad risky. Forward exchange rate enables the exporters and importers of goods to know the prices of their goods which they are about to export or import.

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