It's not unusual for companies to make deals that defer payment until some point in the future. Small businesses and large corporations alike conduct transactions in which payment must wait until a contract is fully executed, a specific time period has elapsed, or certain conditions are met. If the transaction also requires exchanging currencies -- as with importing or exporting goods -- there also must be an agreement on what a fair exchange rate will be at that point in the future. This is called a forward contract; the forward exchange rate is established through combining inflation expectations and the time value of money.
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Calculating the Forward Exchange Rate
Determine the spot price of the two currencies to be exchanged. Make sure the base currency is the denominator, and equal to 1, when determining the spot price. The numerator will be the amount of the foreign currency equivalent to one unit of the base currency. Spot currency prices can be found on most full-service financial websites.
For example, say your base currency is the U.S. dollar (USD) and the foreign currency is the Freedonian pound (FDP). You currently get 3 Freedonian pounds to the dollar, so the spot price of USD to FDP is 3.
Find the interest rate in the country where the base currency is used. The interest rate is used to account for the time value of money and inflationary expectations in the base country. The interest rate can be found on the website of the country's central bank. Say the applicable interest rate in the U.S. is 5 percent. or 0.05 when expressed as a decimal.
Find the interest rate in the country where the foreign currency is used. This accounts for the time value of money and inflationary expectations in the foreign country. Say the interest rate in Freedonia is 10 percent. or 0.1 when expressed as a decimal.
Plug the numbers into the forward exchange rate equation, with "n" being the number of years until payment:
Forward Exchange Rate= (Spot Price)*((1+foreign interest rate)/(1+base interest rate))^n
In the example:
Forward Exchange Rate= 3*(1.1/1.05)^1= 3.14 FDP = 1 USD. In one year, 3.14 Freedonian pounds will equal $1 U.S.