Forward Exchange Rate
The agreed future exchange rate implied by interest-rate differentials (covered interest parity).
Formula
Variables
Example
S 1.10, i_d 5%, i_f 3%: F ≈ 1.121
How it works
This formula gives the no-arbitrage forward exchange rate implied by the current spot rate and the interest rates in the two currencies. It works because an investor should be indifferent between exchanging money now and investing domestically, or converting at the spot rate, investing abroad, and locking in the future exchange rate; if the forward rate were different, a risk-free profit would be possible. The domestic currency in the numerator and the foreign currency in the denominator reflect the growth in value of each cash flow over the contract period.
When to use it
Use this when pricing or checking a currency forward contract, especially in FX trading, treasury management, and international finance. It is also used when testing whether quoted forward rates are consistent with covered interest parity.
Worked example, step by step
Suppose the spot exchange rate is S = 0.80 USD per EUR, the domestic interest rate is i_d = 6%, and the foreign interest rate is i_f = 2%. F = S × (1 + i_d) / (1 + i_f) F = 0.80 × (1.06 / 1.02) F = 0.80 × 1.039215686... F = 0.831372549... So the forward exchange rate is approximately 0.8314 USD per EUR.
Common mistakes to avoid
- Using percentage values like 6 and 2 instead of decimal rates 0.06 and 0.02
- Reversing the domestic and foreign interest rates in the formula
- Confusing the spot rate quotation direction, which changes the numerical result
Did You Know?
If forward rates strayed from this formula, riskless arbitrage would instantly push them back into line.
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