Forward Exchange Rate
The forward exchange rate is the rate of exchange of one currency for another at a specified future date. Forward exchange rates are used by investors and businesses around the world to hedge against exchange rate risk. Exchange rate risk is the risk that a currency’s value will change before the completion of a transaction due to changes in market supply and demand. In order to minimize or even eliminate this risk, an investor or business will use a forward exchange rate.
Forward exchange rates offer a variety of benefits to those dealing in international finance. Forward exchange rates allow an investor to purchase a currency in advance at a predetermined rate and then use the currency when they need it. This eliminates the need to buy the currency at or near the time of the transaction. It also eliminates the risk of becoming exposed to sudden exchange rate movements that could negatively affect the investors profit. Because the investor knows the rate of exchange, they have the ability to accurately budget for upcoming transactions and more accurately measure their bottom line.
The forward exchange rate is determined by a contract between the two parties involved. The contract is based on expectations of future market conditions related to the currency exchange rate. The parties involved will agree to the terms of the contract and the exchange rate. The rate is based on the spot rate, which is the official rate, at the time of the transaction, plus the expected currency exchange rate differential over the life of the contract. There are two main approaches to forward exchange rate contracts. The first is the outright forward exchange rate, and the second is the forward points approach.
The outright forward exchange rate approach determines the exchange rate in the future by factoring the spot rate and the currency exchange rate differential. The difference is determined by analyzing forces like inflation, interest rates, and the strength of the economy between the countries or regions involved. The currency exchange rate differential is taken into account with an interest rate differential component.
The forward points approach sets the forward exchange rate in points, rather than a specific exchange rate. This approach typically involves a much shorter time span than the outright approach. The buyer and seller of the currency will agree to a number of points in either direction to reflect the difference between the actual exchange rate and the expected exchange rate at the time of the transaction.
Using forward exchange rates is becoming increasingly common amongst hedgers and speculators. If a hedger is expecting to receive money in a certain currency, they can use a forward exchange rate to lock in a rate on the future exchange. This reduces their risk of earning less if the exchange rate moves against them. Speculators can also use forward exchange rates to make money off the expected exchange rate too, using the same strategies that hedgers use to limit their risks.
Forward exchange rates are always fluctuating and buyers and sellers must be aware of how these fluctuations can impact their business. However, for many businesses and investors, forward exchange rates offer an effective way to hedge against the negative impacts of exchange rate movements.
