What Is a Forward Parity?

Forward parity is a theory in economics relating to currency exchange rates. It deals with forward exchange rates, which are those that investors agree to use on a fixed future date, regardless of the actual rate at that time. Forward parity is the theory that, as an overall average, the forward exchange rates will prove to match the actual rates on the relevant dates and thus be a prediction tool. Some economists believe that even when this proves not to be the case, it can be informative to try to find patterns that explain the theory's apparent failure.

The reason forward parity can exist as a concept is that not all currency exchanges are made immediately. Instead, many traders make a deal for a currency exchange in the future on a set date, known as a forward exchange, for a variety of reasons. Some do so simply for certainty, for example with a company that has agreed to take a payment in foreign currency from a customer on a future date but wants or needs to know now exactly what it will get in domestic currency. Some do so as a hedge tactic that means they can limit their losses if exchange rates move in a way that hurts their business or investments. Some traders simply use such deals as a form of speculation, trying to profit from making the correct prediction, for example completing the deal as agreed and then immediately converting the money back at the more favorable market rate of the time.

At any time there are two types of currency rate: the spot rate, which is the market rate for immediate exchanges; and forward rates, which is the current market rate for forward exchanges. There are a range of forward rates, each covering a specific future date such as 30 or 90 days in advance. Forward parity is the theory that forward rates will match the actual spot rate on the relevant date and thus are a predictive tool.

The logic of the theory is relatively simple. It works on the basis that when people negotiate a forward rate, they do so based on a belief of what the spot rate will turn out to be on the relevant date. Logically, one party will agree a forward rate that they expect to be below the actual spot rate, while the other party will expect the actual spot rate to be higher than the forward rate. On average, particularly across an entire busy market for forward exchanges, people should get their predictions too high or low in roughly equal measures and the real spot rate will fall right in the middle. In theory, investors negotiating a forward price should wind up at this price because they compromise on a forward rate that splits the risk evenly between the two parties.

In reality, forward parity rarely if ever proves to be correct. Not only do the forward and spot prices rarely match, but in some studies the spot price moved in the opposite direction to what was expected. Economists have tried to find patterns in why this happens. One theory is that the market for forward exchanges is distorted by the fact that interest rates vary from country to country, leading to large variations in demand for currency from investors who want to take advantage of high interest rates in a particular country.