Forward Exchange is a type of foreign exchange transaction whereby a contract is made to exchange one currency for another at a fixed date in the future at a specified exchange rate. It is the contract of purchase or sale of foreign currency for delivery at a future date at a price agreed upon at the time of arranging for the purchase or sale. It is a special type of foreign currency transaction. By this operation, the buyer or seller is protected from any adverse fluctuations in the rate of exchange between the date of the forward contract and the date of delivery. These rates are determined by the relationship between spot exchange rate and interest or inflation rates in the domestic and foreign countries. By buying or selling forward exchange, business protects themselves against a decrease in the value of the currency they plan to sell at a future date.
Forward Exchange are agreements between two parties to exchange two designated currencies at a specific time in the future. These contracts are a mutual hedge against risk as it protects both parties from unexpected or adverse movements in the currencies’ future spot rates. The term may also refer to the rate fixed for a future financial obligation, such as the interest rate on a loan payment. These contracts enable importers and exporters who will make and receive payments in a foreign currency at a future time to protect themselves from fluctuations in the rate of exchange.
Forward Exchange Calculation –
These rates can be obtained for twelve months into the future; quotes for major currency pairs (such as dollars and euros) can be obtained for as much as five to ten years in the future. The forward exchange rate for a contract can be calculated using four variables:
- S = the current spot rate of the currency pair
- r(d) = the domestic currency interest rate
- r(f) = the foreign currency interest rate
- t = time of contract in days
The formula for the forward exchange rate would be: Forward rate = S x (1 + r(d) x (t / 360)) / (1 + r(f) x (t / 360))
For example, assume that the U.S. dollar and Canadian dollar spot rate is 1.3122. The U.S. three-month rate is 0.75%, and the Canadian three-month rate is 0.25%. The three-month USD/CAD forward exchange contract rate would be calculated as:
Three-month forward rate = 1.3122 x (1 + 0.75% * (90 / 360)) / (1 + 0.25% * (90 / 360)) = 1.3122 x (1.0019 / 1.0006) = 1.3138.
The exchange rate is comprised of the following elements:
- The spot price of the currency
- The bank’s transaction fee
- An adjustment (up or down) for the interest rate differential between the two currencies.