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How Forward FX Rates are Calculated

The Premium or Discount is a mathematical calculation of the differential in interest rates for any given period, between borrowings in one currency and deposits in another currency. They can be expressed as percentages or in absolute amounts. THEY ARE NOT A PREDICTION OF THE FUTURE SPOT RATE.

Many newspapers calculate and publish the actual forward rate. However, Forward Premiums and Discounts obtained from a bank are usually quoted in pairs.

This is demonstrated in the following examples:

1 Month	2 Months	3 Months
0.35 - 0.45c.disc	0.60 - 0.70c.disc	0.80 - 0.90c.disc
0.0008 - 0.0006c.pm	0.0009 - 0.0008c.pm	0.0010 - 0.0009c.pm
1.33 - 1.35c.disc	1.37 - 1.39c.disc	1.39 -1.41c.disc

(These figures are for indication purposes only)

Importer wants to buy US dollars for delivery in one month.
Using the Spot and Forward rates:

The bank's one month forward selling rate for US dollars would be calculated as follows:

Spot Rate US $1.4150

Add I-month Forward Discount US $0.0035

US $1.4185

Exporter wants to sell Euros for delivery in three months.

The bank's three month forward buying rate for Euro would be calculated as follows:

Spot Rate EUR1.6435

Deduct three month Forward Premium EUR0.0009

EUR1.6426

NOTE: Spot Rates are quoted in the major unit of the currency, e.g. Dollars, Euro, and Yen

Forward Rates are quoted in the smaller unit of the currency, e.g. cents.

The forward Premiums and Discounts are mainly based on the relative borrowing/deposit interest rates available from the money markets in the financial centres concerned.

EXAMPLE

Forward FX Contract in Practice

Exporter Selling US$100, 00 for

Spot Rate: US$1.60

3-month forward: US$1.58

Spot in 3-months time: US$1.67

At expiry in 3-months:

If US$ are received as expected, exporter converts at the Forward FX Contract rate and receives £63,292.14 instead of the £59,880.24 he would have received at the Spot Rate prevailing at the expiry date if he had not taken out Forward FX cover.

The exporter has achieved certainty, irrespective of movements in the Spot FX rate.

He knows he will receive £63,291.14 for his US$100,000 payment.

If the US$ did not arrive, the exporter must still meet his obligations under the Forward FX Contract, as follows:

Exporter must buy at Spot FX Rate, cost = £59,880.24

He must then sell dollars to meet the expiring Forward FX Contract, receipt = £63,291.14

Net receipt = £3,410.90 - GAIN

However, had the FX rate moved against the exporter, to say US$1.50/£, there would have been a net LOSS to settle the deal, as follows:

Exporter buys Dollars at Spot FX Rate of US$1.50, cost = £66,666.66

He must then sell the dollars to meet Forward FX contract, receipt = £63,291.14

Net cost = £3,375.52 - LOSS

Option Dated Forwards

The examples given so far are for the calculation of Forward Rates for a fixed date. More often or, the exact payment date is uncertain. For these common circumstances banks can quote a rate for a range of payment dates, such as 'payment in July'. This would fix a rate for settlement of the FX contract on any business day in the month of July.

As banks are risk averse, the rate that is the fixed is the one that is most favourable to the bank and the least favourable to the exporter.

Cross Rates

Whilst the major currencies are quoted against each other, e.g. USDollar/Sterling, USDollar/Yen, Sterling/Euro, USDollar/Euro, Sterling/Yen and the minor currencies are quoted against the Usdollar, or the Euro, often this is not the rate of exchange needed.

What is more often required is a Cross Rate of Exchange.

A Cross Rate of Exchange is a rate between two currencies calculated via a third currency. For example, to calculate the Mexican Peso/Sterling rate it is necessary to use the US Dollar as the third currency.

First you convert the Mexican Peso to US Dollars, and then convert USDollars to . You then know how many Mexican Pesos it will buy take to buy how much

For example, where:

MXN Pesos10.8271 = $US1.00

$US1 = £0.6312

The cross rate of exchange would be 10.827 = 17.153

0.6312

This only demonstrates the technique. The rate used is the Spot mid-rate. In practice two rates are usually quoted, the buying and the selling rate. So it is important to keep in mind exactly what is happening, otherwise it is easy to get confused.

Suppose a Mexican importer wishes to pay £10,000 for some goods from the . How many Mexican Pesos does he need?

The importer has to sell Mexican Pesos and buy US Dollars. He then sells the US Dollars to buy

Let us assume that the buying and selling Spot Rates are:

Pesos/$US 10.7187 - 10.9353

$US/£ 0.6249 - 0.6375

The bank always sells low and buys high so the bank buys 10.9353 pesos for one Dollar. That dollar will buy £0.6249.

Therefore the rate of exchange Peso/£ is: 10.9353/0.6249 = 17.499

Therefore if the importer is buying Spot then he has to find 174,992 Mexican Pesos to pay the exporter £10,000.

If the importer plans ahead and hedges his currency risk by buying Sterling forward, then the normal conventions for deducting premiums and adding discounts to the Spot Rate have to be applied.