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 1 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) 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.

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. Forward contracts are considered a form of derivative since their value depends on the value of the underlying asset, which in the case of FX forwards is the underlying currencies. The main reasons for engaging in forward contracts are speculation for profits and hedging to limit risk. although hedging lowers foreign exchange risk, it also eliminates the opportunity cost of potential profits.

So if a United States company agrees to a forward contract to exchange $1.25 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 $1.25 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 is this forward exchange rate calculated? It cannot depend on the exchange rate 1 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.

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.

(Read Currency Quotes first, if you don’t know how currency is quoted.)

Calculating the Forward Exchange Rate

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:

Future Value of Currency (FV) Formula