Forward Rates vs Spot Rates
There are two different types of currency exchange rates. The first and most simplest to explicate is the spot exchange rate. The spot exchange range is merely the current exchange rate as opposed to the forward exchange rate. Forward exchange rate essentially refers to an exchange rate that is cited and traded now but for payment and delivery on a set future date. on certain occasions, a business requirements to do foreign exchange transaction but at some time in the future. For instance, a British company might make a sale of its goods internationally, but will not receive payment for at least one year. So how is it able to price its products or goods without knowing what the foreign exchange rate, or spot price as it is called, will be among the the Euro and the United States dollar, 1 year from now. It can do so by entering into a forward foreshorten that permits it to lock in a specific rate in 1 year so that they can be in be in agreement upon a set exchange rate without knowing exactly what it will be.
A forward contract is an be in agreement, by and large with a bank, to exchange a specific amount of currency at one time in the future for a specific rate, the forward exchange rate. Computing this forward exchange rate is the difficult part since how can you predict the future?? Obviously, it can't be decided established on the exchange rate in a years time since it is impossible for people to predict what that will be. All that is currently known is the spot exchange rate, today, but a forward price cannot merely equal the spot price, since the money could have been securely invested to earn interest with organizations such as banks, so the future value of the amount is larger than its current value and they would have with a possibility lost money. The employ of these forward contracts are in general by bigger transactions and business firms so the amount lost in possible interest can frequently be quite substantial.
A fair way of doing would be if the current exchange rate of a particular currency with respect to a base currency equals the current value of the currency, then the forward exchange rate should equal the future value of the quote currency and the future value of the base currency, as if it doesn't, then an arbitrage opportunity arises. So the future value of a currency is the present value of the currency + the interest that it brings in over time in the country of issue. The mathematical symbol for this way of computing the Future Exchange rate would be: FV = P (1+r)<sup>n</sup> In this equation, the FV stands for the future value of the currencies, the future exchange rate. P denotes to the principal. r denotes to rate of interest per year and of course n, stands for the number of years.
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