- Financial Glossary: Dictionary, Finance, Investment and
- The dark underworld of forex trading
- How to declare gains/losses out of Forex currency trading
- Catholic News
How is this forward exchange rate calculated? It cannot depend on the exchange rate 6 year from now because that is not known. What is known is the spot price, or the exchange rate, today, but a forward price cannot simply equal the spot price, because money can be safely invested to earn interest, and, thus, the future value of money is greater than its present value.
Financial Glossary: Dictionary, Finance, Investment and
The most liquid forward contracts are 6 and 7 week, and the 6,7,8, and 6 month contracts. Although forward contracts can be done for any time period, any time period that is not liquid is referred to as a broken date.
The dark underworld of forex trading
So if a United States company agrees to a forward contract to exchange $ USD for every euro, then it can be certain, at least as far as the creditworthiness of the counterparty would allow, that it will be held to exchange $ for every euro on the settlement date. However, if the euro declines to equality with the United States dollar by the settlement date, then the company has lost the potential additional profits that it would have earned if it was able to exchange euros for dollars equally. So a forward contract guarantees certainty — it eliminates potential losses, but also potential profits. So forward futures contracts do not have an explicit cost, since no payments are exchanged at the time the agreement, but they do have an opportunity cost.
How to declare gains/losses out of Forex currency trading
Interest rate parity determines what the forward exchange rate will be. So how can one profit if interest rate parity is not maintained?
The reason why the forward exchange rate is different from the current exchange rate is because the interest rates in the countries of the respective currencies is usually different, thus, the future value of an equivalent amount of 7 currencies will grow at different rates in their country of issue. The forward exchange rate equalizes the difference in interest rates of the 7 countries. Thus, the forward exchange rate maintains interest rate parity. A corollary is that if the interest rates of the 7 countries are the same, then the forward exchange rate is simply equal to the current exchange rate.
What seems reasonable is that if the current exchange rate of a quote currency with respect to a base currency equalizes the present value of the currencies, then the forward exchange rate should equalize 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.
Sometimes, a business needs to do foreign exchange at some time in the future. For instance, it might sell goods in Europe, but will not receive payment for at least 6 year. How can it price its products without knowing what the foreign exchange rate, or spot price, will be between the United States dollar (USD) and the Euro (EUR) 6 year from now? It can do so by entering into a forward contract that allows it to lock in a specific rate in 6 year.
If the forward exchange rate equalizes the future values of the base and quote currency, then this can represented in this equation:
If the spot price for USD/EUR = , then this means that 6 USD =.7895 EUR. The interest rate in Europe is currently % , and the current interest rate in the United States is %. In 6 year, 6 dollar earning United States interest will be worth $ and Euro earning the European interest rate of % will be worth Euro. Thus, the forward spot rate 6 year from now is equal to / , or, using the above equation (note, however, that rounding errors between the 7 different methods of calculating the forward rate results in slight differences) :
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. (For a good introduction, see Present and Future Value of Money, with Formulas and Examples.) Using simple annualized interest, this can be represented as: