Currency Forward Contracts

• A currency forward contract involves two currencies and two interest rates. A currency forward contract lets you lock-in a pre-defined price at which you can buy/sell a currency on a future date.
• Contract parties commonly enter into currency forwards with the objective of hedging exchange rate risk exposure.
• The interest rates can be interpreted as a net cash flow yield of investing one currency in a risk free asset and borrowing the other currency.

Price of a Currency Forward with Simple Compounding:

F(0,T)_X/Y = S_0,X/Y × ((1+r_X)/(1+r_Y))^T

Where:

• S0 = Spot exchange rate for X/Y (#X units domestic per 1Y foreign) at initiation
• rX = Risk free rate in country X (domestic currency)
• rY = Risk free rate in country Y (foreign currency)

Price of a Currency Forward with Continuous Compounding

F(0,T)_X/Y = (S_0,X/Y e^-ry^T ) e^rx^T

Value of a Currency Forward with Simple Compounding

V_t(0,T)_X/Y = (S_t,X/Y / (1+r_Y)^(T-t)) - (F(0,T)_X/Y / (1+r_X)^(T-t))

Value of a Currency Forward with Continuous Compounding

V_t(0,T)_X/Y = (S_t,X/Y e^-ry^(T-t)) - (F(0,T)_X/Y e^-rx^(T-t))