The forward rate isn’t an unbiased prediction of future spot rate because such a claim would mean that you would be
able to predict the very detail of every subsequent event leading up to the date of the forward rate from today's spot
rate date. Although this claim is not as outrageous when it is done in the short term. Over longer terms, this
assumption of the forward rate being an unbiased predictor of future spot rate is simply too naive because factors such
as change in interest rate, market sentiment, government policies change, etc is sometimes way too sudden and
unpredictable. Therefore we can only assume that the current forward rate is only the expected price of the future
spot rate based on all the currently available information and condition; when these conditions change and new
information is available, market participants will naturally change their expectations and prediction of the future spot
rate, thus changing the forward rate.
Moreover on the changes in interest rate, one of the factors that determines the exchange rate of currency between
2 countries. Based on the International Fisher Effect, it is stated that the disparity in exchange rate between two
currencies should be the same as the disparity between the interest rate of the two countries. This is derived based on
the assumption that real interest rate is similar and constant internationally between countries where:
𝑅𝑒𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 = (𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒)
As such, when a country's expected inflation rate increases the interest rate will also have to match the increase to
maintain the constant real interest rate. We can then apply the Purchasing Power Parity theory and find that because
countries have different Expected Inflation and Nominal Interest rate, we can measure the difference of either one
between the 2 countries to figure out the disparity of its currency exchange rate.
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑡𝑖𝑎𝑙 = 𝑖𝑎 − 𝑖𝑏 , in which 𝑖 is the nominal interest of country a and b,
respectively.
It is implied, in the case that this differential in the exchange rate is not the same as the difference in nominal interest
rate or Expected Inflation Rate, assuming there is no friction cost, there would be an arbitrage opportunity to be taken
advantage of by investors and traders. This arbitrage will then bring balance to the disparity between the currencies
due to the law of supply and demand.
This relationship between nominal interest rate and exchange rate movement can then be derived into:
𝑒𝑓 =
1 + 𝑖ℎ
1 + 𝑖𝑓
− 1
Where 𝑒𝑓 is the change in the exchange rate between 2 currencies, and 𝑖ℎ & 𝑖𝑓 is the nominal interest rate of the
home and foreign country, respectively. For example assume the home country and foreign country nominal interest
rate is 11% and 12%, respectively. We can compute the number into the formula as such
𝑒𝑓 =
1 +11%
1 +12%
− 1=
− 0. 89%
That number is the percentage of depreciation/appreciation a foreign currency must experience based on the theory.
For example, let's assume the exchange rate of USD/IDR 15.000, if the home country is Indonesia ( IDR ). Then the USD
would have to depreciate by 0.89% becoming USD/IDR 14.866,5. Thus using this new adjusted exchange rate, the real
return of home investors investing in foreign deposits would be equal to 11%, the stated nominal interest rate of their
home country. Which can be proven using the following formula:
𝑟 = 1(1 + 𝑖𝑓)(1 + 𝑒𝑓) − 1 = 1(1 + 12%)(1 + 0. 89%) − 1 ≈ 11%
In conclusion, the International Fisher Effects concludes that inflation rate and expected inflation rates tend to move
in tandem, influencing the exchange rate of each currency with another; the implication of this would mean that both
foreign and home investors' real return would be the same after the change happened. This theory is one of many
factors that influences the prices of forward rate, but due to the unpredictable nature of other factors aside from this
one, forward rates is still not an exact unbiased prediction of future spot rate. Theory and calculations might be able to
predict with high accuracy to some degree but the underlying numbers and assumptions that are being used have not
yet been able to predict every single change in the factors affecting the spot rate, now or even in the future.