Spot & Forward Currency Relationship
Financial markets are tied together by a vast web of currencies, each with its own value relative to the others.
These values are not static and fluctuate based on various factors including economic performance, geopolitical events, and policy decisions.
One of the primary mechanisms by which these currency values are determined is through the relationship between spot and forward currency pricing.
This dynamic not only influences currency valuations, but also shapes international trade, investment decisions, and economic policies.
Below we look at the relationship between spot/forward currency pricing and the impact of interest rate differences on this relationship.
Additionally, we’ll examine the consequences of managed currency decline, the role of capital controls, and the typical duration of the currency defense phase.
Key Takeaways – Spot & Forward Currency Relationship
- Understanding the relationship between spot and forward currency pricing is essential to understand their impact on international trade, investment decisions, and economic policies.
- The interest rate differential plays a vital role in the spot/forward currency relationship.
- Expectations of future currency depreciation can lead to higher domestic interest rates, capital withdrawals, and devaluation speculation, which can further worsen the economic situation.
- Capital controls are often ineffective in preventing capital outflows and may create panic (capital flight by those who don’t want to be trapped).
- During the currency defense phase, central banks burn through reserves to stabilize the currency, but this phase is usually short-lived and can have significant consequences if such savings are exhausted.
The Interest Rate Differential and Spot/Forward Currency Relationship
The relationship between a) the interest rate differential and b) the spot/forward currency relationship is important.
The amount a currency is expected to decline is incorporated into how much lower the forward price is than the spot price.
For instance, if the market anticipates a currency to decrease by 5% in a year, it will require a 5% higher yield from that currency.
For policymakers dealing with currency-related inflation (i.e., the currency depreciates, leading to more expensive imports), they need to be mindful of this because this represents how much interest rates will need to rise to help create a two-way market for the currency and halt the inflationary pressure.
This becomes even more significant when the expected depreciation is over shorter periods.
If a 5% depreciation is expected over a month, the currency will need to yield a 5% higher interest rate over that month – and a 5% monthly interest equals an annual interest rate of approximately 80% (not 60% because it’s a compounded rate – [(1+0.05)^12 – 1]) – a rate that’s likely to produce a severe economic contraction in an already fragile economy.
Because a small expected currency depreciation (such as 5 to 10% per year) equals a large interest rate premium (5 to 10% per year higher), this path becomes untenable.
Consequences of Managed Currency Decline and Falling Reserves
A managed currency decline accompanied by dwindling reserves results in the market anticipating continued future currency depreciation.
This situation elevates domestic interest rates, acting as a constriction during a time when the economy is already vulnerable.
Furthermore, the anticipation of continuous devaluation stimulates capital withdrawals and devaluation speculation, widening the balance of payments gap and forcing the central bank to deplete more reserves to protect the currency.
A currency defense by spending reserves will have to stop as no prudent policymaker will want to exhaust what are essentially national savings.
These sequences usually occur just before the cycle progresses to its next stage, which is letting the currency go.
Forward Currency Price and Spot Price Relationship
During the currency defense (e.g., raising interest rates, expending reserves to buy one’s own currency), the forward currency price usually declines ahead of the spot price.
This outcome is a result of the link between the interest rate differential and the spot/forward currency pricing discussed earlier.
If the country tightens monetary policy to support the currency, it will usually widen the interest rate differential to artificially sustain the spot currency. Although this assists the spot, the forward will continue to decline relative to it.
Consequently, there is a whip-like effect where the forward tends to lead the spot downward as the interest rate differential increases.
The spot eventually catches up after the currency is let go (i.e., policymakers stop supporting it), and the decrease in the spot exchange rate allows the interest differential to narrow, causing the forward to rally relative to the spot.
Spot and Forward Exchange Rates Explained in 5 Minutes
The Inefficiency of Capital Controls
At this point in the cycle, capital controls become a third (often last-ditch) lever that rarely proves effective.
Although they might appear attractive to policymakers because they directly result in fewer people withdrawing their capital from the country, history shows that they usually fail because a) people find ways to bypass them and b) the very act of trying to trap people motivates them to escape.
The inability to withdraw money from a country is akin to the inability to withdraw money from a bank: the fear of it can incite a run.
However, capital controls can sometimes serve as a temporary solution, but they never provide a sustainable fix.
The Currency Defense Phase Duration
Typically, this currency defense phase of the cycle is relatively short, approximately six months, with reserves drawn down about 10-20% before the defense is abandoned.
FAQs – Spot & Forward Currency Relationship
What is the relationship between the interest rate difference and the spot/forward currency relationship?
In foreign exchange, interest rate differentials play a role in the determination of spot and forward exchange rates.
The basic concept is based on the theory of interest rate parity which states that the difference in interest rates between two countries is equal to the difference between the forward exchange rate and the spot exchange rate.
This relationship is essential to understand because it affects the spot/forward currency relationship.
In a situation where the market expects a currency to decline, that anticipated depreciation will be factored into the forward price, which will be set below the spot price.
The extent of this expected depreciation often equates to the additional yield required from that currency.
For instance, if the market expects a currency to fall by 5% over a year, it will require that currency to yield a 5% higher interest rate to maintain an equilibrium exchange rate.
How does the expectation of future currency depreciation impact domestic interest rates?
When the market expects future currency depreciation, this can act as a tightening on domestic interest rates.
In a situation where the currency is managed and is declining with falling reserves, the market will generally predict this trend to continue.
Consequently, domestic interest rates are pushed up as the higher interest compensates for the expected currency depreciation.
This higher interest rate serves as a form of tightening at a time when the economy may already be weak, thus compounding the economic strain.
What impact does expectation of currency devaluation have on capital withdrawals and devaluation speculation?
Expectation of currency devaluation often spurs an increase in capital withdrawals and devaluation speculation.
Investors/traders/citizens, wary of the depreciating currency, may opt to withdraw their capital and invest elsewhere where returns may be safer and more robust.
This act, in turn, widens the balance of payments gap and forces the central bank to spend more of its reserves to defend the currency, exacerbating the situation further.
How does the forward currency price behave relative to the spot price during a currency defense?
During a currency defense, it’s common to observe the forward currency price decline ahead of the spot price.
This behavior is a consequence of the relationship between the interest rate differential and the spot/forward currency pricing.
When a country tightens its monetary policy to support the currency, it’s essentially increasing the interest rate differential to artificially bolster the spot currency.
While this supports the spot, the forward continues to decline relative to it, leading to a whip-like effect where the forward leads the spot downward as the interest rate differential increases.
What are capital controls and why are they usually ineffective?
Capital controls are measures taken by a country’s government to restrict the flow of foreign capital in and out of the domestic economy.
These can include taxes, tariffs, legislation, or volume restrictions.
While capital controls can seem attractive to policymakers because they directly reduce capital outflows, history has shown that they often fail.
The two main reasons are a) people typically find ways to circumvent them and b) the act of trapping people’s money creates a sense of panic, leading them to find ways to escape.
Capital controls are, at best, a temporary fix but not a sustained solution.
What usually happens during the currency defense phase of the cycle?
During the currency defense phase of the cycle, central banks typically burn through their foreign exchange reserves in an attempt to stabilize the currency.
This phase is usually brief, often around six months, with reserves drawn down about 10 to 20 percent before the defense is abandoned.
The abandonment often comes with repercussions for the economy, including potential default on foreign debt and severe economic contraction.
However, each currency crisis is unique in various ways, and the duration and severity of the defense phase can vary.
How does currency depreciation lead to inflation?
Currency depreciation can lead to inflation through several mechanisms:
When a country’s currency depreciates, it becomes more expensive to import goods and services from other countries.
This increase in the cost of imports can lead to higher prices for imported goods in the domestic market.
As a result, the prices of various imported products, including raw materials and finished goods, rise, leading to inflation.
Currency depreciation can increase the cost of imported inputs, such as commodities, energy, and raw materials, which are essential for domestic production.
When businesses face higher input costs, they often pass on these costs to consumers by increasing the prices of their products.
This cost-push inflation can affect a wide range of industries and lead to a general increase in the overall price level in the economy.
Increase in Domestic Demand
Currency depreciation can make domestically produced goods relatively cheaper compared to imported goods.
This shift in relative prices can stimulate domestic demand as consumers and businesses prefer locally produced goods over imports.
Increased demand, in turn, puts upward pressure on prices as producers raise their prices to meet the higher demand, resulting in inflation.
External Debt Burden
If a country has a significant amount of external debt denominated in foreign currency, depreciation can make the debt burden more expensive to service.
To meet their debt obligations, the government may resort to printing more money or borrowing domestically, which increases the money supply.
The increased money supply without a corresponding increase in the production of goods and services can lead to inflation.
Currency depreciation can trigger speculative activities in the foreign exchange market.
Traders and investors may anticipate further depreciation and engage in speculative buying of foreign currency or assets.
This speculation can lead to an increase in the demand for foreign currency, putting further downward pressure on the domestic currency’s value.
In response, the central bank may intervene by injecting more money into the economy, which can contribute to inflationary pressures.
Note that the relationship between currency depreciation and inflation is not always direct or immediate.
Other factors such as the country’s monetary policy, fiscal policy, supply and demand dynamics, and overall economic conditions can also influence the inflationary effects of currency depreciation.
Understanding the interplay of spot/forward currency pricing and the role of interest rates is important for not just policymakers but also for businesses and investors/traders navigating the global economy.
A small change in interest rates or expectations of future currency depreciation can trigger ripple effects that impact the currency’s value, which in turn can shape economic realities.
Furthermore, policy measures such as capital controls, while seemingly attractive, are rarely effective in the long run and can exacerbate market fears.
A currency defense is often brief, but it can have lasting repercussions on a country’s economic health.