Suppose you agree to receive payment at a future date in a different currency or plan to pay someone at a future date in a foreign currency. In that case, you can use a forward exchange rate formula to agree with the other party to lock in a given exchange rate. This will protect both parties from volatility.
Forward Contracts, Exchange Rates and Inflation
Businesses often defer giving or collecting payment until a future date, such as after a contract has been fully executed after certain conditions are met or after a certain amount of time has elapsed. That delay means that you won't have the money in hand to invest and earn interest on for the duration of the delay, losing out on the time value of the money. In such situations, businesses will typically factor the time value of the money into the contract, such that the eventual payment will be slightly more than the base value of the goods, assets or services.
Many such deals also involve exchanging currencies, such as importing or exporting goods or performing services for clients in different countries. In such cases, the exchange rate between the two relevant currencies must be taken into account.
Spot Exchange Rates and Inflation Rates
When an exchange is executed at the current moment, or "on the spot," the "spot rate" is used to mediate between currencies. Writers for The Corporate Finance Institute explain that the spot exchange rate is the market price of trading a given currency with a second currency. (In practice, the spot rate is used within two business days of the agreement.) But if the exchange is to take place at some time in the future, how are the parties supposed to predict the exchange rate and settle on a fair one?
One factor that affects exchange rates is the rate of inflation of the respective currency. If their inflation rates are different, then their exchange rate in the future will, even if all other factors remain equal, be different from the spot rate. The forward exchange rate formula accounts for the spot rates, differing inflation rates and money's time value.
The Forward Exchange Rate Formula
There are two versions of the forward exchange rate formula, as shown in the XPlaind article on forward exchange rates. When considering the relative purchasing power of the two currencies, the inflation rates of the two currencies are used. When accounting for the time value of the money and the inflation rates, the domestic and foreign interest rates are used.
These values can be obtained from finance sites or the country's central bank. In both cases, the first step is to get the spot exchange rate in terms of domestic or base currency units per single unit of foreign or target currency. This is notated as s in the following formula: f = s * [(1 + Id)/(1 + If)]^n, where f is the forward exchange rate in terms of units of domestic currency per unit of foreign currency, Id is the domestic inflation or interest rate and If is the foreign inflation or interest rate. Finally, n is the number of periods. You can also use a forward exchange rate calculator such as those available from Investing.com or Iota Finance.
Foreign exchange rates are used in forward contracts, which are a type of foreign exchange or FOREX/FX derivative. The Corporate Finance Institute explains that derivatives are a type of contract whose value is linked to the value of an underlying asset. The team at Forex Traders lists several types of FX derivatives, but keep in mind that, as the CFI warns, derivatives are complex financial instruments. Consult with a financial expert before engaging with FX derivatives.
Consider also: Types of Foreign Exchange Rates