When you plan a transaction in a foreign currency, you often need to lock in a forward exchange rate. This is the rate at which you will exchange foreign currencies at a specific point in the future. The rate is based on today's exchange rate, but is adjusted based on prevailing interest rates for each type of currency. Although most banks will do the work of calculating the foreign exchange rate for you, the process itself is quite simple and can help you understand how banks determine the rate.
1. Look up the spot price, which is the current rate at which you can trade one currency for the other. This information can be found on many financial websites and newspapers. For example, if the spot price for converting dollars into pounds is 0.85, this means that $1 buys you 0.85 of a pound.
2. Look up the risk-free interest rate for your domestic currency. You can find this on financial websites or in newspapers. For example, assume your risk-free rate for U.S. dollars is 0.5 percent.
3. Look up the risk-free interest rate for the foreign currency. For example, you may learn that the risk-free rate for pounds is 8 percent.
Calculate Forward Exchange Rate
1. Convert the risk-free interest rate for the domestic currency to its decimal form by dividing it by 100. Add 1 to the result. For example, 0.5 percent interest for U.S. dollars becomes 0.005, and you add 1 to get 1.005.
2. Raise the answer to the power of the number of years forward you're calculating the interest rate. For example, if you need a two-year forward rate, calculate 1.005 to the second power to get 1.010025. This is the multiplier you would use to calculate how much money you would have in U.S. dollars in two years in a risk-free investment here.
3. Convert the risk-free interest rate for the foreign currency to its decimal form by dividing it by 100, and add 1 to the result. For example, 8 percent for pounds becomes 0.08, and you add 1 to get 1.08.
4. Raise the answer to the power of the number of years forward. In this case, calculate 1.08^2 to get 1.1664. This is the multiplier to show you how much your money would multiply in pounds in two years in a risk-free investment there.
5. Divide the domestic multiplier by the foreign multiplier to calculate the ratio of equivalent future currencies. In this case, 1.010025/1.1664 is 0.8659.
6. Multiply the ratio by the current spot price to calculate the forward exchange rate. In this example, 0.8659 times 0.85 is 0.736. This is the rate you would get quoted today to exchange U.S. dollars into pounds in two years.
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