Do forwards have an effect on exchange rates?

Yes, forwards do have an effect on exchange rates, but the relationship is nuanced. Here’s a detailed breakdown:

1.

What Are Forward Exchange Rates?

A forward exchange rate is the agreed-upon rate for a currency pair at a future date, used primarily for hedging or speculation. It is determined by:

• The spot rate (current exchange rate)
• Interest rate differentials between the two currencies
• Time to maturity of the forward contract

Formulaically:

Forward Rate ≈ Spot Rate × (1 + interest rate of domestic currency) / (1 + interest rate of foreign currency)

2.

Impact on Actual Exchange Rates (Spot Rates)

While forward rates don’t directly determine spot exchange rates, they can influence them through expectations and capital flows:

a.

Expectations and Signaling

• Forward rates embed expectations about future economic conditions (interest rates, inflation, etc.).
• Traders and investors look at forward premiums or discounts to infer likely monetary policy moves.
• A currency trading at a forward discount might signal expected depreciation, influencing short-term market sentiment and spot trading behavior.

b.

Arbitrage and Covered Interest Parity (CIP)