Treasury Today Country Profiles in association with Citi

The forward outright rate

A forward outright is a means of hedging against currency movements by locking in an exchange rate for an FX transaction on a future date. This article outlines how to calculate the forward outright rate.

‘Spot’ transactions on the foreign exchange market are generally settled two working days after the trade is agreed (though there are a few exceptions, including USD/Canadian dollar, USD/Turkish lira, USD/Philippine peso and USD/Russian rouble, which can be settled in one working day).

It is also possible to agree that the trade of one currency for another will be settled at any set date in the future. This arrangement is referred to as a ‘forward contract’. It is important to note that the forward rate is entirely unrelated to any futures market. In a currency futures market, prices are specified at which currencies can be traded at a future date.

The ‘forward outright rate’ is based on the spot rate at the time the transaction is agreed. However, because time elapses between the agreement and the actual transfer of currencies, the interest rates of both currencies are also taken into account whilst calculating the forward exchange rate.

By convention, when currency pairs (eg EUR/GBP) are quoted, the first named currency is known as the ‘base’ currency in the transaction, and the second is the ‘variable’ currency. For example, when a corporate is selling euro, that ‘base’ level is fixed, when the currency being bought (eg GBP) is ‘variable’, changing over time relative to the euro.

Forward outright rate = spot rate x 1 + variable currency interest rate  x  days to settlement days in year 1 + base currency interest rate  x  days to settlement days in year

Note: By further convention, for the purposes of foreign exchange calculations most countries count 360 days in the year.

To give a worked example, assume a France-based treasurer needs GBP in one month’s time. The treasurer could buy GBP at the spot rate, and deposit the money for a month to gain interest before the GBP is actually needed. However, by using the forward outright rate the treasurer ‘locks in’ the spot exchange rate and keeps the euros for another month before exchanging them at the time GBP is needed.

Assume that the interest rate in the UK is 0.9% and in the Eurozone is 0.7%, and that the current spot rate is 0.8522. EUR, as the first quoted currency, is the base currency and GBP is the variable currency. This means €1 currently buys £0.8522.

In this case:

Forward outright rate = 0.8522 x 1 + 0.009  x  30 360 1 + 0.007  x  30 360 = 0.8532

Note that the value of the currency with the lower interest rate appreciates relative to the other currency in the transaction.

As an example, assume a EUR/GBP exchange rate of 0.75. Spot €100 is worth £75. If the EUR interest rate is 10% and the GBP interest rate is 5%, in one year’s time the original €100 will be worth €110 and the £75 will be worth £78.75 – a relative forward exchange rate of 0.72. That means each euro buys 0.03 fewer GBP, and so sterling has appreciated.