Forward rates, generally speaking, represent the difference between the price of something today versus its price at some point in the future. The variance results from a few factors which depend upon whether one is discussing forward rates for currencies, bonds, interest rates, securities or some other financial instrument.
What is a Forward Contract?
A forward contract on foreign currency, for example, locks in future exchange rates on various currencies. The forward rate for the currency, also called the forward exchange rate or forward price, represents a specified rate at which a commercial bank agrees with an investor to exchange one given currency for another currency at some future date, such as a one year forward rate.
The investor buys a forward contract or buys the currency forward to lock in the exchange rate. In this case, market fluctuations and external economic forces, such as interest rate differentials, become the drivers that affect the currencies’ forward rates.
Companies that do business in several countries often enter into forward contracts for currencies they will use to pay future liabilities in other countries while protecting themselves from overpaying if the other country’s currency becomes stronger against their home currency.
How Do You Calculate Spot Rates?
In any given transaction, spot rates are determined by buyers and sellers rather than by a calculation. The spot rate or spot price of a security, such as a commodity, is the value of the instrument at the moment someone gives you a price quote on it.
If you trade a financial instrument, such as buying foreign currency, the spot rate is determined on the spot date, which occurs two days after the trade on the trade settlement date.
Calculating Forward Rates From Spot Rates
In theory, a forward rate formula would equal the spot rate plus any money, such as dividends, earned by the security in question less any finance charges or other charges. As an example, you could buy a forward contract on an equity and find that the difference between today’s spot rate and the forward rate consists of dividends to be paid plus a discount for anticipated negative price changes on the stock.
The forward and spot rates have the same relationship with each other as a discounted present value and future value have if you were calculating something like a retirement account, wanting to know how much it would be worth in 10 years if you put a certain amount of dollars into it today at a specified interest rate.
How Is a Forward Exchange Rate Determined?
Forward exchange contracts are agreements where a company agrees to purchase a fixed amount of foreign currency on a future specified date. The company makes the purchase at an exchange rate that has been predetermined.
The company, by entering into the contract, protects itself from future fluctuations in the exchange rate for the foreign currency. This allows the business to protect itself against losses on foreign currency fluctuations. Additionally, companies may buy forwards to speculate on exchange rate fluctuations to generate gains for themselves.
The foreign currency exchange rate consists of the following components: the currency’s spot price, any transaction fee for the bank and adjustments made to account for the difference in interest rates between the two different currencies.
The country that has a lower interest rate trades with a premium, while the higher interest rate company trades with a discount. If the U.S. currency interest rate is below that of another country's rate, the counterparty bank adds a fee, or points, to its spot rate. This pushes up the cost of the forward contract.
For example, say that you have a spot rate for GBP, or British pounds sterling, of 1.5459 British pounds to the U.S. dollar. The bank assigns a 15-point premium (.0015) on a one year forward rate contract, so the forward rate becomes 1.5474. This does not include an additional transaction fee.
- When calculating the values of the investments in Step 2, use the correct method of compounding interest (annual, semi-annual, continuous) for the particular investment. The forward rate should use this method as well.
Cynthia Gaffney has spent over 20 years in finance with experience in valuation, corporate financial planning, mergers & acquisitions consulting and small business ownership. She has worked as a financial writer and editor for several online finance and small business publications since 2011, including AZCentral.com's Small Business section, The Balance.com, Chron.com's Small Business section, and LegalBeagle.com. A Southern California native, Cynthia received her Bachelor of Science degree in finance and business economics from USC.