Many traders, in their daily trading activity, buy or sell currencies by observing the current exchange rates and changes in expectations. Let’s take, for example, EURUSD trading and study the effects of an expected future EURUSD exchange rate increase on the current exchange rate level.
Given the current exchange rate, an expected appreciation of the euro against the dollar causes an increase in the expected dollar depreciation rate. If the current EURUSD exchange rate is 1.10 and the exchange rate from here to one year is expected to be 1.15, the expected depreciation rate of the dollar against the euro is (1.15 – 1.10)/1.10 = 4.5%. If the expected future exchange rate increases further, the expected depreciation rate also increases accordingly.
As an increase in the expected dollar depreciation rate translates into an increase in the expected dollar yield of euro-denominated deposits, the oversupply of dollar-denominated deposits leads to a depreciation of the dollar against the euro.
We can therefore conclude that, ceteris paribus, an increase in the expected future exchange rate translates into an increase in the current EURUSD exchange rate, suggesting traders to buy euros. Likewise, a decrease in the expected future exchange rate causes a decrease in the current EURUSD exchange rate, suggesting traders to sell euros.