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Your Business Risks

Your Business Risks

How are forward exchange rates determined?

As an SME, it's common to be exposed to currency exchange rate risk. Whether you import, export, or do a combination of both, it's crucial to have in place a defined plan on how to protect your business against currency exchange rate risk.

When importing goods, a depreciation in your domestic currency will make purchases become more expensive and result in additional costs for your business. Conversely, an appreciation in your domestic currency means that you will receive less when converting overseas denominated revenues back into your domestic currency.

Two main instruments are available in the market that can help protect your businesses future cash flows against the unpredictability of exchange rate movements.

They are Futures and Forwards.

While the two instruments contrast in some respects, one of the main similarities between them is the way the forward rate (or future/forward price) is calculated.

How is the forward rate calculated?

For currency exchange rates, it is all to do with interest rate differentials: the difference between the interest rates available in the quote currency country relative to the base currency country. This can be expressed via the below formula:

Day count conventions used in the forward rate calculation are the same as that used in the country’s respective money market, which means that the day convention will vary for each currency. For example, both the euro and dollar use Actual/360-day count, whereas the UK uses Actual/365.

Iq: Interest rate in the country of the Quote currency (e.g. USD in EUR/USD)

Ib: Interest rate in the country of the Base currency (e.g. EUR in EUR/USD)

Thus, the prevailing interest rates in any given two countries determine whether a forward rate will be trading at a discount or premium.

Example of buying EUR and selling USD (EUR/USD).

A European software company will be receiving one million of US dollar denominated revenues in three-months’ time. They want to protect their cash flows against the risk of an appreciation in EUR (or deprecation in USD) by the time they convert their dollar denominated revenues back into euros. They therefore enter into a three-month forward.

Example A - Premium to spot rate

Current EUR/USD spot rate= 1.0303.

US interest rates are 4% and EU interest rates are 2%.


Forward rate = 1.0303 x 1.0050 = 1.0354.

A premium of 0.0051 or 51 pips.

What does this mean?

As we can see, the forward exchange rate is higher than the spot rate and is trading at a premium. The premise of trading at a discount or premium is to prevent arbitrage opportunities: which simply refers to an opportunity of generating a risk-free profit by taking advantage of interest rate/pricing differentials between different products.

Example B - Discount to spot rate

Current EUR/USD spot rate= 1.0303

In this example US interest rates are 3% and EU interest rates are 4.5%

Using the same scenario as before, for a 3-month forward:

Forward rate = 1.0303 x 0.9963 = 1.0265

A discount of 0.0038 or 38 pips

With interest rates now higher in the EU in comparison to the US, the forward exchange rate is trading at a discount to the spot rate. This is to compensate the holder of USD who is earning 1.5% less in interest compared to the holder of EUR, for a period of 3 months.

It is important to note that the forward rate is purely a mathematical calculation based on the premise of interest rate parity and does not reflect any market expectations of the future.

If you're interested in learning more about how WieldMore helps companies protect their cash flows against foreign exchange risks, get in touch and one of our market specialists will be happy to help.


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