Fri 24 Jun 2016 21:16 GMT

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Spot Exchange Rate vs Forward Exchange Rates

A forward contract is an agreement, usually with a bank, to exchange a specific amount of currencies sometime in the future for a specific rateāthe forward exchange rate. Calculating this forward exchange rate is the difficult part because how can you predict the future?? Obviously, it can't be decided based on the exchange rate in a years time because it is impossible for people to predict what that will be. All that is currently known is the spot exchange rate, today, but a forward price cannot simply equal the spot price, because the money could have been securely invested to earn interest with organisations such as banks, so the future value of the amount is bigger than its current value and they would have potentially lost money. The use of these forward contracts are generally by bigger transactions and firms so the amount lost in possible interest can often be quite substantial.

A fair way of doing would be if the current exchange rate of a particular currency with respect to a base currency equals the current value of the currencies, then the forward exchange rate should equal the future value of the quote currency and the future value of the base currency, because, as we shall see, if it doesn't, then an arbitrage opportunity arises. So the future value of a currency is the present value of the currency + the interest that it earns over time in the country of issue. The mathematical symbol for this way of calculating the Future Exchange rate would be: FV = P (1+r)<sup>n</sup> In this equation, the FV stands for the future value of the currency or as earlier discussed, the future exchange rate. P refers to the principal. r refers to rate of interest per year and of course n, stands for the number of years.

« Exchange Rates - What are they and how are they calculated?