12 Dec at 9 AM
Big foreign exchange decision?
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There are two different types of currency exchange rates. The first one and most simplest to explain is the spot exchange rate. The spot exchange range is simply the current exchange rate as opposed to the forward exchange rate. Forward exchange rate essentially refers to an exchange rate that is quoted and traded today but for delivery and payment on a set future date.Sometimes, a business needs to do foreign exchange transaction but at some time in the future. For example, a british company might make a sale of its goods internationally (in this case we will say a European country), but will not receive payment for at least one year. So how is it able to price its products or goods without knowing what the foreign exchange rate, or spot price as it is called, will be between the United States dollar (USD) and the Euro (EUR) 1 year from now? It can do so by entering into a forward contract that allows it to lock in a specific rate in 1 year so that they can agree upon a set exchange rate without knowing exactly what it will be.
A forward contract is an agreement, usually with a bank, to exchange a specific amount of currencies sometime in the future for a specific rate—the 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.
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