Question

(Uncovered interest parity) What is the relationship among the forward exchange rate, the spot exchange rate, and the interest rate? Suppose the (1-year) interest rate on bank deposits is 2% in Canada and 1.5% in United States. If the (1-year) forward US$–C$ exchange rate is C$1.5 per US$ and the spot rate is C$1.2 per US$, what is the expected US$–C$ exchange rate one year ahead?

Answer 1

Spot exchange rate is the exchange rate at which two currencies get exchanged for market exchange rate at that point of time I.e. on spot where as in forward exchange rate we decide today an exchange rate at which two currencies we can exchange in future time.

This is the main difference in between two exchange rates.

Relation between forward and spot exchange rate can be given as follows

F(Forward exchange rate)=S(Spot exchange rate)×(1+interest rate in domestic country)/(!1+rate in foreign currency country)

When we exchange currencies one is assumed to be domestic and other to be foreign currency most of the time USD is foreign currency.

In a given example

Foreign exchange rate=1.2×(1.02/1.015)=1.2×1.005==1.0251=1.03

As per the formula of uncovered interest Parity expected forward exchange rate should be 1.03 C$ for every 1 US$