Forward Exchange Rate

Forward exchange rate is the exchange rate at which a party is willing to enter into a contract to receive or deliver a currency at some future date.

Currency forwards contracts and future contracts are used to hedge the currency risk. For example, a company expecting to receive €20 million in 90 days, can enter into a forward contract to deliver the €20 million and receive equivalent US dollars in 90 days at an exchange rate specified today. This rate is called forward exchange rate.

Forward exchange rates are determined by the relationship between spot exchange rate and interest or inflation rates in the domestic and foreign countries.

Formula

Using the relative purchasing power parity, forward exchange rate can be calculated using the following formula:

f = s × 1 + Id n
1 + If

Where,
f is forward exchange rate in terms of units of domestic currency per unit of foreign currency;
s is spot exchange rate, in terms of units of domestic currency per unit of foreign currency;
Id domestic inflation rate;
If is foreign inflation rate; and
n is number of time periods

Using the covered interest rate parity, forward exchange rate is calculated using the following formula:

f = s × 1 + id n
1 + if

Where,
f, s and n stand for the same as stated above;
Id domestic interest rate; and
If is foreign interest rate.

Example

Exchange rate between US$ and British £ on 1 January 2012 was $1.55 per £. This is our spot exchange rate. Inflation rate and interest rate in US were 2.1% and 3.5% respectively. Inflation rate and interest rate in UK were 2.8% and 3.3%.

Estimate the forward exchange rate between the countries in $/£.

Solution

Using relative purchasing power parity, forward exchange rate comes out to be $1.554/£

f = $1.5507/£ × 1 + 3.3% n= $1.554/£
1 + 3.3%

Using the interest rate parity, forward exchange rate is

f = $1.5507/£ × 1 + 2.1% n= $1.5401/£
1 + 2.8%

Actual exchange rate was $1.6244/£. US$ has depreciated more than predicated by the relative purchasing power parity and interest rate parity.

Written by Obaidullah Jan