Foreign Exchange Forward Rate
The foreign exchange forward rate is a concept relative to the spot exchange rate. It refers to the exchange rate agreed upon by buyers and sellers for a transaction that will be settled at a specified future date, rather than immediately. A forward foreign exchange transaction is a type of pre-arranged trade. When engaging in such transactions, both parties typically sign a forward contract, which includes details such as the transaction date, amount, and forward exchange rate. Upon the contract's maturity, regardless of the spot exchange rate, both parties must execute the transaction at the agreed-upon forward rate.
(1) The Role of Forward Exchange Rates
The forward exchange rate is the mandatory rate used by traders in forward foreign exchange transactions. By setting a forward exchange rate, traders can hedge against potential exchange rate risks by locking in a predetermined rate. Additionally, traders may use forward transactions for speculation to earn investment profits. For example, if a trader anticipates that a currency's exchange rate is currently low but likely to rise, they can purchase a forward contract to buy the currency at the agreed rate upon maturity and then sell it at the prevailing spot rate to profit from the difference. However, due to the unpredictability of financial markets, such speculative activities carry inherent risks.
(2) Calculation Method of Forward Exchange Rates
Formula: Forward Rate = Spot Rate + Spot Rate × (B Borrowing Rate - A Borrowing Rate) × Forward Days / 360
This formula shows that the forward exchange rate depends on the spot rate of the currency pair, the interest rate differential between the two currencies, and the duration of the forward contract. If the interest rate differential is positive, the forward rate will be higher than the spot rate, known as a premium. Conversely, if the differential is negative, the forward rate will be lower than the spot rate, referred to as a discount. Moreover, a longer forward period amplifies the impact of the premium or discount on the forward rate. This is because extended durations increase uncertainty in exchange rate trends, thereby influencing the forward rate under unchanged conditions.
Example Calculation:
Suppose the spot USD/CNY rate is 1 USD = 6.8676, the 1-month Shibor (Shanghai Interbank Offered Rate) is 3.1210%, and the 1-month Libor (London Interbank Offered Rate) is 0.07813%. The 30-day forward rate would be calculated as:
Forward Rate = 6.8676 + 6.8676 × (3.1210% - 0.07813%) × 30 / 360 = 6.8850
Thus, the 30-day forward USD/CNY rate is 1 USD = 6.8850 CNY.
Forward exchange rates can be quoted in two ways:
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Outright Rate Method: The forward rate is directly stated without indicating the premium or discount.
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Points Method: The forward rate is expressed in terms of premium or discount points, requiring traders to calculate the final rate based on the spot rate.
