Forward exchange rates

[wrongsaidfred]

Hi David,

This may be another very dumb question, but what exactly is a "forward exchange rate"? Is this just what the exchange rate will be at some point in the future or does this have anything to do with what we considered a forward rate when dealing with interest rates, FRAs, etc.?

Sorry for the lame question, but the terminology is making my head hurt a bit.

Thanks,
Mike

 

[David Harper CFA FRM]

Hi Mike,

Yea the FX terminology makes my head hurt too, really. The basic building block is the "forward exchange rate" and here is a set of them that together constitute a forward curve of the EUR/USD: http://www.cmegroup.com/trading/fx/g10/euro-fx.html
(consistent with our treatment of commodities, as these trade, these are futures contracts. They are "forward rates," but as they are exchange-traded, we could forgive the usage "futures exchange rates" or "futures foreign exchange rates")

In this way, as Hull shows (and I really think this is the place to start), currencies are investment commodities and so the model-implied forward exchange rates can be predicted by the cost of carry model (you made an earlier point about Hull vs. McDonald: McDonald would not refer to currencies as carry markets as there are no storage. I am ignoring that...) is the same model used for all commodities because the foreign rate is economically like a dividend:

F(0,T) = S(0)*exp[(rate_domestic - rate_foreign)*T]

This is the model-implied forward exchange rate, that predicts the forward rates we can CURRENTLY OBSERVE at CME.

So think of this like any other commodity.
Just like other forwards/futures, if you want to be a future buyer of the commodity (Euro currency), you can currently enter a long position in the futures contract (March 2013,eg) which has a forward exchange rate of EUR/USD $1.3472, so you are promising to purchase one unit of the commodity (1 Euro) for USD $1.3472.

In this way, the forward FX rate is not the expected future spot foreign exchange rate (which cannot be observed, we must wait for the future!), the forward FX rate, just like (eg), the futures prices of gold are corn, are today's prices for later delivery/purchase.

In this way, also, the "forward (foreign) exchange rate" is not to be confused with a "forward interest rate" (which itself is contracted/transacted by way of an FRA, Eurodollar futures contract, or any number of other instruments).

I hope that helps, David