Forward Contract Pricing – Calculating Forward Exchange Rates
The pricing of a Currency Forward Contract is a relatively straight-forward concept based on three factors.
The first factor is the current spot rate for the currency pair,
The second factor is the interest rate differential between the two currencies involved in the trade (e.g. the difference in the base rate in the UK & EU for GBPEUR trades)
The third is the time until the contract matures.
If the pricing of a Currency Forward Contract would have been any different from these principles, there would be an arbitrage opportunity as investors would be able to take advantage of the difference in interest rates to trade Forward Contracts and make a profit.
No Judgement in Forward Exchange Rates
It is tempting to assume that a forward exchange rate carries some kind of implicit forecast surrounding potential currency movements.
However, this is not the case, as the forward rate is a purely mechanical function of interest rate differentials, the time to duration for the contract to mature and the current rate.
Even if a currency appears substantially out of line with fundamentals, the forward rate will not make assumptions of any kind of correction, forecast or mean reversion.
This is different to the situation in the options market where there is always an implied judgement of future trends expressed in demand and supply.
When to Use Currency Forwards?
The use of a Forward Contract is particularly useful when a period of transaction uncertainty traverses a major economic or political event.
The 2016 UK referendum on EU membership was a clear example of such an event.
If a UK buyer of overseas property signed a contract just before the referendum, but the funds were not deliverable until after the referendum, there was a very clear and substantial currency risk.
Predicting Exchange Rate Movements
Similarly, there will be a strong case for taking out a currency Forward Contract if there is an income flow in an overseas currency and sterling is very weak from a historical perspective.
For example, any sterling move towards parity against the dollar or Euro would be extremely attractive based on rates which have prevailed over the past 30 years.
It’s important to note, however, that rates could move for or against you after a Forward Contract has been booked – FX rates are constantly moving at every second of the day.