How Forward Exchange Rate is Determined?
If you run a company with a global base of suppliers, partners, or customers, you have probably heard about the forward exchange rate. It is a vital financial tool that you can use to hedge currency exchange risks. How is the forward exchange rate determined?
Exchange rates can have a significant impact on your currency transaction costs. It can result in losses or profits, depending on the extent of currency fluctuation. If you suspect that the changes will result in losses, a forward contract can be a perfect solution.
We look at the basics of the forward exchange rate, including its pros and cons. We’ll also show you how to calculate the forward exchange rate.
That said, let’s look at what the forward exchange rate is.
What is the Forward Exchange Rate
Foreign exchange rates are highly volatile and can fluctuate depending on the interest rates, inflation rates, and other economic factors. In extreme volatility, the exchange rates can fluctuate by even 10 percent, affecting returns after currency exchange.
A forward exchange rate is the interest rate applicable to future financial transactions that involve different currencies. The contract allows you to lock in the current exchange rate for future use. So, any change in exchange rates won’t affect the locked-in rate.
If you fail to lock in the current exchange rate for future use, you’ll end up paying more than what you bargained for in the past. A forward contract allows you to fix the current exchange rate and create a straightforward budget, guaranteeing future costs.
When it comes to bonds, forward rates can help you determine future values. For instance, an investor can buy a one-year treasury bill or a six-month bill to be rolled into another six-month account when it matures.
If both investments generate the same total return, then the investor will be indifferent. The investor may know the spot rates for the six-month bill and one-year bond but not the value of the six-month bill to be bought six months from the current date.
In the foreign exchange market, most people generally use forward contracts to hedge currency risks. You can tailor the contracts for specific requirements, unlike the future agreements with fixed contract sizes and expiry dates, hence cannot be customized.
Suppose a Canadian exporter has a large export order pending for transit to Europe. The exporter wants to exchange 10 million euros for Canadian dollars at a forward rate of 1.45 EUR/CAD in 60 days.
The Canadian exporter has the mandate to deliver the 10 million euros at the current forward rate on a future specified date. Any change in the status of the export order or the EUR/CAD exchange rate for the 60 days will not affect the locked exchange rate.
Calculating Exchange Rates Using the Forward Exchange Rate Formula
You can calculate forward exchange rates from the spot rate and adjust them to determine the future interest rate. Some of the factors that will affect the outcome of a forward exchange rate are domestic inflation rates and foreign inflation rates.
Here is the Forward Exchange Rate Formula.
- F is the forward rate
- S is the spot rate
- id is the domestic interest rate
- if is the foreign interest rate
- n is the period of the forward contract
Here is an example.
If the spot rate for the CAD/USD is 1.1239 and the three-month interest rates on the CAD and USD are 0.75% and 0.4% annually (approximately 360 days), respectively, find out a 3-month (90-days) CAD/USD forward rate.
In that case, the forward exchange rate will be:
Advantages of Forward Exchange Rates
Forward contracts come with numerous benefits, including the most obvious one, which allows you to preserve better currency exchange rates for future use.
Here are the other advantages of forward exchange rates:
- Relatively cheaper to maintain
- Very easy to set up and maintain
- Allows you to buy now and pay later
- Hedges your exposure to currency exchange risks
- You can roll it over until after the original settlement
- It helps you prepare an accurate budget for future transactions
- Allows to manage the costs of importing goods from overseas
- Forward contracts are customizable as you can write any amount and term
- You can match them against the period of exposure and the cash size of the exposure
Disadvantages of Forward Exchange Rates
While a forward contract is an indispensable tool for hedging currency exchange rates, the odds can also work against you.
A forward contract usually protects international businesses from losses if the value of the dollar goes down. However, there’s usually a possibility that the value could go up.
So, if the dollar value increases, you may remain locked into a rate lower than the market rate. That may expose your business to more risks of losses.
Here are the few drawbacks of using forward exchange rates:
- Prevents intermediate cash flows before the contract’s maturity date
- If the currency fluctuates in your favour, you’ll miss the gains
- Finding a counterparty can be quite challenging
- Cancelling a forward contract is not easy
- The agreement is subject to default risks
Should You Use a Forward Contract or Not?
Now that you know the pros and cons of forward contracts, you wonder if it’s the right choice for you. Much will depend on what risks your business can stand and your attitude towards the risks.
If you can withstand a little risk or your international business can weather any drop in the currency value, the other tools for tracking rates can help you manage international payments effectively.
When you want to lock in lucrative exchange rates for future international money transfers, consider doing it at Knightsbridge Foreign Exchange. We are the leading provider of option-dated forward contracts to private clients and global businesses.
Contact us today to enjoy consistent bank beating currency exchange rates every day.