Distinguish between spot and forward foreign exchange markets and critically discuss the relationship between spot and forward rates in these markets. Is forward foreign exchange market useful?
A spot market is a foreign exchange market where transactions are carried out on the spot while forward foreign exchange markets are markets where foreign exchanges buying and selling is for delivery in the future. The prices of foreign exchange and its delivery in the spot foreign exchange markets are determined in real-time and therefore it affects the transactions in the foreign exchange market. This implies that it is instantly affected by changes in the financial markets. The rates in the spot foreign exchange market indicate the amount of money the buyer is willing to use in the purchase of foreign currency using a different currency. These spot markets are mainly for requirements that are fast and require urgency. These requirements include the deposits for the purchase of land.
Since the exchanges in the spot market are only meant to last for a short period, it is possible to extend their validity up to a certain date through the use of a spot contract or a forward contract. A spot contract aims at locking an exchange up to a specific date which is close i.e, one to two business days while the forward contract is purchased to lock the exchange to a future date. Changing the validity of an exchange in a spot market effectively changes it to exchange in the forward foreign exchange market.
The transactions in the spot market are complete i.e, purchase and delivery are done on the same day. This is different from the forward markets where purchases are made on that particular day but the exchange is done in the future. Forward rates are the rates used in the forward markets signifying foreign currency’s future contract rates. The rate is settled at the time when the transaction is taking place but the actual delivery of the exchange is at some prior agreed point in time. Forward exchange markets are advantageous to both the buyer and seller. The buying rates in these forwards markets is higher than the selling rates.
The forward foreign exchange market is important especially in the management of risk. Through the forward foreign exchange market, it is possible to ensure that no losses are accrued from the purchase and sale of goods which are abroad. In the case that one wants to purchase an item abroad and decides to engage the forward foreign exchange markets then the value of the item will not change for the period agreed between the parties. Taking another example of financial analysts determining the currency to use in its reserves. If a country’s experts speculate on the loss of value of the currency, they may decide to purchase exchanges in the forward markets. This is advantageous in that the decline in the economy may be stopped by the money held in reserves. Exchanges from the forward markets despite the purchasers do not lose value over the period. Taking the example of an investor from China who wants to purchase a property in the United Kindom using their Chinese Renminbi as the currency. If the investor decides to purchase forward bonds for three years, the investor has the option to pay the sa,e price for the whole period specified in the forward contract. The forward markets will ignore any changes on the Renminbi or economy of China that occur during the time of contract.