Interest Rates

Interest Rates

As discussed previously, forward exchange rates are expressed as a forward discount or a forward premium. The most common reason as to why they are higher or lower than the current spot rate is due to the interest rates of the 2 countries involved in the currency exchange.

Indirect Quote Example

Say the current spot rate is:

USD 0.7500 AUD

Meaning $1 Australian Dollar equals 75 US cents. If the forward rate was then quoted as:

USD 0.7450 AUD

Then it would mean that $1 Australian Dollar equals 74.5 US cents or in other words the forward rate is lower than the spot – i.e. forward discount. This would be the case if Australian interest rates are higher than that of the U.S. and that the Australian dollar is expected to depreciate against the US dollar. As in the future 1 Australian Dollar will buy you less US currency. Put simply the Australian Dollar is now worth less than what it was before. Or the US dollar is now worth more than what it was before. Remember that the above exchange rate has been represented in an indirect quote.

Direct Quote Example

To represent the same example above in a director quote would be the following. Say the current spot rate is:

AUD 1.3333 USD

Meaning $1 US Dollar equals $1.33 Australian.  If the forward rate was then quoted as:

AUD 1.3500 USD

The forward margin is now represented as a forward premium to have the same affect as the first example. This is because to change from indirect to the director form of exchange rate quotes, you must divide 1 over the previous quote – 1/0.75 = 1.3333. Or in other words to find the inverse of the quote. By finding the inverse, all of the things from the following example must be reversed, to maintain the overall picture that the AUD $ is now worth less and that the USD is now worth more. Or, in terms of interest rates, Australian interest rates are higher than that of the U.S. and that the Australian dollar is expected to depreciate against the US dollar.

However, if the story was that Australian interest rates are lower than that of the U.S., then the reverse of the outcomes would occur. In this example the US dollar would now be worth less, and the AUD dollar would now be worth more.

The theory behind this form of exchange rate adjustment according to interest rates is called Interest Rate Parity (PPP). This theory basically acknowledges the fact that most countries will have different interest rates, in comparison to other countries. Due to this difference and the floating exchange rate system (exchange rates are freely moving and determined by market forces) then the exchange rates will depreciate or appreciate according to the difference in the interest rates between each country.