Define each of the following terms: e. Interest rate parity; purchasing power parity
Define each of the following terms:
Spot rate: Spot rate is the exchange rate paid to purchase a currency for its immediate delivery. There should be a negligible time gap between the purchase and delivery of the currency.
Forward exchange rate: Forward rate is the agreed rate, which is to be paid to buy currency, which would be delivered at a certain future date. There is a predetermined time gap between the actual exchange of currencies of two countries. However, the rate at which currencies will be exchanged is decided on the basis of current rate. Forward rate can only be anticipated as it is subject to fluctuations, depending upon changes in bilateral trade between the countries.
Discount on foreign currency forward rate: When the foreign currency value depreciates in comparison to the domestic currency, it is said that foreign currency is selling at a discount to the spot rate. Assume that the US dollar is home currency and INR is the foreign currency. When foreign currency is trading at a discount, a dollar can buy more number of foreign currency units in the forward market, than in the spot market. For example, a dollar buys 75 INR in the spot market, if foreign currency is trading at a discount, a dollar can buy more than 75 Rs. in forward market.
Premium on foreign currency forward rate: When the value of the foreign currency in comparison to the home currency appreciates, it is said that forward rate is selling at a premium to the spot rate. In practical terms, it implies that a dollar (Home Currency) buys less units of foreign currency in the forward market (i.e at a future date) as compared to the spot market (current date). For instance, if a dollar buys 70 Rs.(INR) at a current date, and at a certain future date it can buy only 60 INR, then such change is due to appreciation in foreign (here INR) currency.