Forex Rates: Factors Affecting Forward Rates
There are many factors that one way or the other affect the forward rates, or rather forward or swap margins. Generally, forward rate of a currency in relation to another is a function of interest rate differential between the two currencies. In other words, the forward margin, be it premium or discount, tends to be equal to the differential between interest rates of the two currencies concerned. If 2 month sterling deposit in London yields 12% per anum and dollar deposit for the same period yields 9% p.a. , the swap or forward, margin will tend to be equal to 3% on an annualized basis. With interest differential being 3% p.a. the sterling will be dealt in the forward market at a discount of 3 % p.a. or near about in relation to US dollar. Conversely, the premium for US dollar will tend to be around 3% in relation to sterling. It is however , naive to suggest that interest rate differential always dictates the forward margin. In fact, interest rates and forward margins influence each other. For instance, if sterling deposit earns interest at 12% and dollar deposit at 8% p.a. the investors, with invest able dollars will try to switch from dollar to sterling by spot purchase and forward sale of sterling. Oversupply of sterling in the forward market coupled with increased demand for forward dollar will naturally widen the discount. At the same time influx of sterling in pursuit of higher interest rate would tend to reduce its interest rate while outflow of dollar will create shortage and increase interest rates. The two way adjustment process will thus restore the equation between interest differential or what we call ‘interest parity’ and forward margin at an equilibrium level.
