Question

Show how differences in interest rates effect forward rates?

Answer 1

According to interest rate parity forward rates are dependent on the interest rate of foreign and domestic countries. The forward rates are given as follows:

Forward Rate = Spot Rate X (1 + Interest Rate of Foreign country)/(1 + Interest Rate of Domestic country)

Here we have to keep in mind that the domestic country has to be kept as base currency.

The basic premise is that higher the interest rates, higher the loss of value of currency. For example let the rates in US be 2% and rates in India are 7%.
Current spot rate = rupees 50 per 1 USD.

After a years 50 rupees shall be 50*1.07=53.50
After a year dollar shall be =1*1.02=1.02 Dollars
New rate = 53.50/1.02=52.45 rupees/dollar.

Hence we can see that if interest rates are higher there is a depreciation in the currency value.

As per formula: Value = 50*1.07/1.02=52.45 rupees /dollar