16.2 International Imbalance with a Fixed Exchange Rate

		Curiosity 18.2: What Is a Forward Exchange Rate?

		A U.S. firm closes a big deal with a Mexican buyer who will pay 5 million pesos when the product is delivered in three months time. This firm is not in the business of speculating on the future value of pesos, so may understandably be nervous about how many U.S. dollars this foreign currency will buy in three months. To avoid this problem the firm can "hedge" the transaction by entering a contract to sell 5 million pesos in three months at the three-month forward exchange rate. In this way, the firm guarantees how many U.S. dollars the 5 million pesos will buy in three months.

		If the current or spot Mexican peso exchange rate is 4 U.S. cents per peso, then the 5 million pesos would today be worth US$200,000. The person agreeing to buy these 5 million pesos from this firm in three months will want some reward for taking on the risk of an unexpected change in the value of the peso during this three-month period. This reward, which could be called an insurance premium paid by the firm, takes the form of a percentage "discount" of the spot rate to produce the forward rate.

		The spot rate of 4.0 cents per peso could, for example, be discounted to produce a forward rate of 3.95 cents per peso. This implies that the 5 million pesos will in three months provide the firm with US$197,500 instead of the US$200,000 the firm would have received if the forward contract had not been signed and the exchange rate had not changed. The magnitude of the discount depends on what the Mexican peso is expected to do during these three months. If inflation in Mexico exceed inflation in the United States, everyone would expect the Mexican peso to fall (because of the PPP theorem), so the forces of supply and demand in this market should cause the discount to be greater.

		The "Currency Trading" column in the "Money & Investing" section of the Wall Street Journal reports daily the 30-, 90-, and 180-day forward rates for the British, Canadian, French, German, Japanese, and Swiss currencies. The discounts embodied in these forward rates are sometimes used to measure the market's expectations of future relative inflations across countries. As an example, consider the following recent entry for the Japanese yen, reporting the midrange of buying and selling rates among banks for transactions of a million dollars of more.

		Country

		U.S. $ equiv.

		Currency per U.S. $

		Japan (Yen)

		.008405

		118.98

		1-month forward

		.008431

		118.50

		3-months forward

		.008514

		117.46

		6-months forward

		.008628

		115.90

		This example can be summarized as follows: a difference in nominal interest rates that reflects only a difference in inflation rates (and thus does not correspond to a difference in real rates) generates no capital flows because the difference in nominal rates is offset by anticipated changes in currency values. Consequently, the interest rate parity result must be written in terms of real interest rates:

		Foreign real i rate = U.S. real i rate + Risk premium