Forward exchange rates, like spot exchange rates are determined by the demand for and the supply of forward exchange. If the supply of forward exchange exceeds the demand for it, the forward rates will be quoted at a discount over the spot rate i.e., forward exchange rate will be lower than the spot exchange rate. On the other hand, if the demand for forward exchange exceed its supply, the forward rates will be quoted at a premium over the spot rate i.e., forward rate will be quoted at a premium over the spot rate i.e., forward rate will be higher than the spot rate. The demand for forward exchange arise, mainly, from:
An importer of foreign goods having to make payment after a certain period of time may contract to purchase foreign exchange in advance to avoid the risk of changes in exchange rates. Arbitragers move funds from one center to another to earn profits out of the interest differential that may exist between the two centers. An arbitrager who transfers funds abroad to take advantage of a comparatively higher rate of interest abroad, contracts at the same time to sell forward exchange to cover himself against exchange risks. Speculators intentionally take an open or uncovered position expecting to gain from future changes in the exchange rate. If the speculators expect a rise in the exchange rate, they will have an incentive to contract for the purchase of forward exchange. Similarly, the supply of forward exchange comes, mainly from:
- Exporters of merchandise,
- Exporters of capital,
- Arbitragers and
- Speculators.
Forward exchange operation provide an opportunity to traders to safeguard themselves against the risks arising from changes in exchange rates. Normally traders are interested in making their profits by marking up the purchase price by a certain percentage. In foreign trades, the purchase and sale price of the traders is expressed in terms of different currencies. When purchase and sale prices are expressed in terms of different currencies, changes in exchange rate may upset all the calculation of the traders. Risks from changes in exchange rates are particularly high under the system of free and fluctuating exchange rates. Such risks are not very important under pegged exchange rates and gold standard. If the traders wish to avoid these risks and to concentrate on their normal functions (i.e., trading activities), and the risks involved, in these, they can contract in advance to buy or sell foreign exchange, equivalent to the amount of payment they expect to make or receive at a guaranteed rate. Suppose for illustration, that an Indian exporter contracts to export tea to the United Kingdom for which he will receive payment in terms of sterling after ninety days, to avoid the risk of a change in the exchange rate at the time he receives payment, he can contract with his bank in advance to sell the amount of sterling which he expects to receive after ninety days at a guaranteed exchange rate. Similarly, an importer placing an order for goods from the United Kingdom, knowing that he has to make payment in terms of sterling after ninety days, can contract with his bank in advance to buy sterling after ninety days at the guaranteed exchange rate and thus safeguard himself from the risks arising from changes in the exchange rate. Forward exchange facilities also enable foreign investors and foreign debtors to cover themselves against exchange risks. Foreign debtors can avoid exchange risks by contracting in advance to purchase the required amount of foreign exchange at a guaranteed rate at the time their payment fall due. Similarly, the holders of foreign investments and other claims can cover themselves against exchange risks by forward sales.