Forward Rate Calculation

International Finance
FOREIGN EXCHANGE
CALCULATIONS
Learning Objectives
After completing this chapter, you should be able to understand:
What is Forward Rate

How do you calculate Forward Rate based on
formula and schedule
Swap Points
Annualized Forward Margin
Interest Rate Arbitrage
Borrowing & Investment Decisions
Foreign Exchange Calculations
Structure
6.1 Abstract
6.2 Calculation of Forward Rates Through the Use

of Formula
6.3 Calculation of Swap Points
6.4 Features of Forward Rates
6.5 Calculation of Forward Rates Through Schedules

Method (Tables)
6.6 Annualized Forward Margin (AFM)

Structure
6.7 Relationship Between Exchange Rates , Interest

Rates and Commodity Prices
6.8 Interest Rate Arbitrage
6.9 Borrowing and Investment Decisions
6.10 Japanese Yen Carry Trade
6.11 Summary
6.12 Self Assessment Questions

6.1 Abstract
Assume that a forward rate is required to be created

for an import transaction of USD 1 maturing one year
forward. Assume spot USD/INR = 50, INT interest rate
= 6% p.a. and USD interest rate = 3% p.a. Assume
borrowing of INR 50 for one year.
Liability at the end of one year would be:
P 1 + RT = 50 1 + 6 x 1
100 100
= INR 53
6.1 Abstract
The borrowed INR can be used to purchase 1 USD at

the spot price and invested at 3% p.a. for one year.
The USD available at the end of the year would be:
RT 1
P 1 + = 50 1 + 3 x
100 100
= USD 1.03
Thus USD 1.03 can be created against a liability of
INR 53 one year forward. This means that 1 USD gets
created at a cost of INR ( 53/1,03) one year forward.
6.1 Abstract
Therefore 1 year forward USD/INR

53
=
1.03
=
51.4563
Formula for computation of a forward rate n months
forward is provided on the next slide, where
F = Forward rate. S= Spot rate

Rv = interest rate on variable currency.
Rb = interest rate on variable currency.

6.1 Abstract
Rv n
S 1+ x
100 12
F=
Rb n
1 + 100x 12
In case rate is required in terms of days , then replace

n/1 by d/365.
In case days are in multiple of 30 the assume year to

be of 360 days.

of Formula
1. If spot USD/SEK is 5.2425, USD interest rate
is 4.00% p.a. and SEK interest rate is 6.5% p.a. then
calculate USD/SEK rate three months forward.
Rv
n F= 1+ x
Sx
1+ 100 x
12
Rb 6.5
n 1+ x
3
= 5.2425 x 100100
12 1+ x
12
4
3
of Formula
6.5
1+
400
= 5.2425 x
1+ 4
400
= 5.2425 x 406.5 x 400

400
404= 5.2425 x 406.5
404
= 5.2749

of Formula
2. If six month forward USD/SEK rate is
6.8525, SEK interest rate is 7.35% p.a. and USD
interest rate is 3.65% p.a.; calculate the USD/SEK
spot rate Rv
n 1+ x
F= S x 1 + 100 x
12
Rb 7.35 6
n 1+ x
100 12
= Sx 100 3.65 6
12 6.8528 1+ x
100 12
of Formula
7.35
1 +
200
6.8528 = S x
1 +3.65
200
6.8528= S x 207.35
203.35
6.8525 x 203.65
Therefore S =
207.35
= 6.7302

of Formula
3. Given : 1 EUR = USD 1.3485 spot
1 EUR = USD 1.3525 two months
forward
USD interest rate = Rv
4% p.a. Calculate EUR interest
rate.
n 1+ x
1+ 100 x
12 F = Sx
Rb 4 2
n 1+ x
100 12
= 1.3485 x 100
Rb 2
12 1+ x
100 12
1.3502
of Formula
4
1 +
600
1.3502 = 1.3485 x
Rb
1 +
600
Therefore (600 + Rb) = 1.3485 x 604

1.3502
= 603.24
Therefore Rb = 3.24% p. a.
i.e. EUR interest rate = 3.24% p.a.

of Formula
4. Given : Spot GBP/CAD 1.9213.
73 days forward 1.9187. GBP interest rate 3.50 p.a.
Calculate CAD interest rate.
Rv n
1 + 100 x 12
F= Sx
1+ Rbx n
100 12
Rv 73
1+ x
100 365
1.9187= 1.9213 x
3.50 73
1+ x
100 365
of Formula
Rv
1 +
500
= 1.9213 x
3.50
1 +
500
500 + Rv
= 1.9213 x
503.50
1.9187 x 503.50
Therefore (500 + Rv) = 1.9213
= 502.8186
Rv = 2.8186
CAD interest rate = 2.8186% p.a.
1. Given :
Spot GBP/USD 1.9845 1.9855.
USD interest rate 4.1250 4.3750 % p.a.
Calculate swap points ( forward margins ) for three
months Rv n For bid side swap points
1 + 100 x 12 use deposit rate of Variable
F= Sx currency and lending rate of
1+ Rb x n Base currency
100 12
4.1250 3
1+ x
100 12
= 1.9845 x
6.1250 3
1+ x
100 12
404.1250
= 1.9845 x
406.1250
= 1.9747
Therefore swap points

= F S = 1.9747 1.9845
= (-) 0.0098 (1)
For ask side swap points use deposit rate of Base

currency and lending rate of Variable currency.

For ask side swap points

use deposit rate of Base
currency and lending rate of
Variable currency.
Rv n
1 + 100 x 12
F= Sx
1+ Rbx n
100 12
4.3750 3
1+ x
100 12
= 1.9855 x
5.8750 3
1+ x
100 12
404.3750
= 1.9855 x 405.8750
= 1.9782
Therefore swap points
= F S = 1.9782 1.9855
= (-) 0.0073 (2)
Since the swap points are negative they represent
discount on base currency. In all discount situations
the swap points are always in descending order. [L to
R]
Therefore, three months forward margins : 98 -73
Positive swap points represent premium on base

currency. In such cases the swap points are always in
ascending order (from left to right).
When transaction is postponed beyond the spot date,
the seller continues to hold the base currency on
which it is possible to earn the market deposit rates
whereas he is deprived of the variable currency which
would have to borrowed at the market lending rate.
The opposite would be true for calculating the forward
bid rate when two-way interest rates are provided.

Swap points are always

represented in the form of pips.
Therefore, no decimals are indicated.
Factors are presented without positive or

negative signs.
It is understood that factors in ascending order,

left to right , are positive (premium on base
currency) whereas factors in descending order
( from left to right) are negative
(discount on base currency).

2. Given :
Spot USD/CAD 1.0985 1.0095.
CAD Deposit rate : 4.75 % p.a.
USD Deposit rate : 4.00 % p.a.
3 month swap points ; 14 27
Calculate the arbitrage free Lending interest rates for
the two countries.
Spot USD/Cad 1.0985 1.0995

(+) three months premium 14 27
Three months USD/CAD 1.0999 - 1.1022

Rv n
1+ x
100 12
F= Sx Rbx n
1+
100 12
1 + 4.75 x 3
100 12
1.0999 = 1.0985 x Rb 3
1+ x
100 12
Rb = 4.23% p.a.

Rv n
1+ x
100 12
F= Sx Rbx n
1+
100 12
1 + Rv x 3
100 12
1.1022= 1.09995 x 4.00 3
1+ x
100
Rb = 12
4.99% p.a.
CAD Lending rate: 4.99% p.a.
USD Lending rate : 4.23% p.a.
3. Given :
Spot GBP/AUD 1.0985 1.0095.
AUD Lending rate : 2.25 % p.a.
GBP Lending rate : 3.50 % p.a.
6 month swap points ; 169 - 113
Calculate the arbitrage free Deposit rates for the two
countries.
Spot GBP/AUD 2.2950 2.2960

(-) six months discount 0.0169 0.0113
Six months GBP/AUD 2.2781 - 2.2847

Rv n
1+ x
100 12
F= Sx Rbx n
1+
100 12
1+ Rv x 6
100 12
2.2781 = 2.2950 x 3.50 6
1+ x
100 12
200 x Rv
= 2.2950 x
203.50
6
2.2781 x 203.50
(200 + Rv) =
2.2950
(200 + Rv) = 202.00 Therefore Rv = 2.00

AUD deposit rate = 2.00% p.a. (1)
Rv n
1 + 100 x 12
F=Sx Rb n
1+ x
100 12

2.25 6
1+ x
2.2847 = 2.2960 x 100 12
1 + Rb x 6
100 12
202.25
2.2847 = 2.2960 x
200 + Rb
(200 + Rb ) = 2.2960 x 202.25 = 203.25

2.2847
Rb = 3.25 ---- (2)
GBP deposit rate 3.25%
4. Given :
Spot EUR/SGD 1.7480 1.7490
SGD Deposit rate : 3.00 % p.a.
EUR Deposit rate : 2.00 % p.a.
3 month swap points ; 33 - 54
Calculate the arbitrage free Lending rates for the two
countries.
Spot EUR/SGD 1.7480 1.7490

(+) three months premium 33 54
3 months EUR/SGD 1.7513 - 1.7544

Rv n
1+ x
100 12
F= S x Rb n
100 12
3 3
1+ x
1.7513 = 1.7480 x 100 12
Rb 3
1+ x
100 12
403
1.7513 = 1.7480 x
400 + Rb

1.7480 EUR Lending

Rb = x 403 400 = 2.24 % rate
1.7513
Rv n
1+ x
100 12
F= S x Rb n
1+ x
100 12
Rv 3
1+ x
1.7544 = 1.7490 x 100 12
2 3
1+ x
100 12

(400 + Rv )
1.7544 = 1.7490 x
402
1.7544
Rv = x 402 - 400
1.7490
= 3.24% p.a.
SGD Lending
rate

When forward rates are quoted by banks to their

customers, the premium or discount for the forward
maturity is included when quoting the final rate to
the customer. The Exchange margin representing
the profit of the bank is also factored into the base
rate. Such rates are called outright forward rates.
When forward rates are quoted by banks in the
inter-bank market, a schedule of forward margins is
provided along with spot quotations.
Shown next.

Spot USD/INR 41.0625 Spot USD/CHF 1.3625 1.3635
41.0675
1 month forward 650 -700 1 month forward 35 25
2 month forward 1275-1325 2 month forward 65 55
3 month forward 1875 -1925 3 month forward 90 80
6 month forward 3650 - 3700 6 month forward 165 - 155

In a given schedule of forward margins if, LHS

factors are less than the RHS factors, they
represent premium on base currency; whereas if
LHS factors are greater than the RHS factors, then
they represent discount on bases currency.
In a given schedule of forward margins, LHS factors

are added or subtracted to the bid rate in the spot
quotation; whereas the RHS factors are added or
subtracted to the ask rate in the spot quotation

The forward margin factors are added or subtracted

from the extreme right hand decimal place of the
spot rate, because the factors are represented in
the form of pips.
Forward margins are always expressed in terms of
the variable currency and therefore they represent
premium or discount per unit of the base currency.
Each factor in the schedule of forward margins
represents a standalone calculation and there is no
cumulative addition or subtraction when arriving at
forward rates.
The spread of a forward quotation arrived at using

the schedule of forward margins can never be finer
than the spread of the spot quotation.
The schedule of forward margins is presented in

two different ways. The forward margins are either
calculated for standard forward maturities such as
1,3,6 months or in terms of calendar months as
spot/Jan, spot/Feb, etc. (In India, forward margins
are normally presented in terms of calendar
months).

When forward margins are presented in terms of

standard maturities, assume 1 month = 30 days
and 1 year = 360 days whereas when margins are
presented in terms of calendar months , the
calculations represent the actual days for that
month.
In such cases 1 year = 365 days.

BROKEN DATE FORWARD QUOTATIONS
From a given schedule of forward margins, if a

quotation is required to be calculated for a date
falling between two standard maturities, then such
quotations are using the Principle of Interpolation.
This means that a quotation is first obtained for

standard maturity and pro rata premium or
discount for the balance number of days between
the first and the second maturity is calculated to
obtain the required quotation.
RULES REGARDING FORWARD DATES
Forward maturities are always calculated in relation
to the spot rate. Example, 1 month forward contract
dated 25th January, maturity date would be 27th
February, i.e. one month from the spot date of 27th
January.
If a conventionally calculated date falls on a
holiday, at either of the locations, then the next
working day is treated as maturity date.
If 27th February is a
Sunday, then the maturity
will be 28th February
The conventionally calculated maturity forward date
in terms of months must tally with the number of
calendar months.
For example , If 28th February is a holiday,

either in India or at the foreign centre then the
forward date would be 25th February, as 26th 27th
being week ends, the Foreign exchange markets are
closed.

If conventionally calculated forward date does not
exist in a particular month, the the last working day
of the month is considered as the maturity date.
A three month forward contract dated January 29th

would conventionally mature on 31st April. But
since no such date exists, the contract would
mature on 30th April

6.5 Calculation of Forward Rates Through the Use of
Example # 1. Given : Schedules (Tables)
Spot USD/INR 40.0625 Spot USD/CHF 35 -25
40.0675
1 month forward 650 - 700 1 month forward 35 -25
3 month forward 1875 - 1925 3 month forward 90 - 80

Schedules (Tables) First INR
Spot USD/INR rate 40.0625 40.0675

(+) 1 month premium 0.0650 0.0700
1 month rate 40.1275 - 40.1375
(+) 2 month premium 0.1275 0.1325
2 month rate 40.1900 - 40.2000
)
(+) 3 month premium 0.1875 0.1925
3 month rate 40.2500 - 40.2600

Schedules (Tables) Now Swiss Francs
Spot USD/CHF rate 1.3625 1.3635

(-) 1 month premium 0.0035 - 0.0025
1 month rate 1.3590 1.3610
(-) 2 month premium 0.0065 - 0.0055
2 month rate 1.3560 1.3580
)
(-) 3 month premium 0.0090 0.0080
3 month rate 1.3535 - 1.3555

Schedules (Tables)
2. Based on above data calculate the one
month and three month CHF/INR quotations. [Note:
When calculating forward cross rates, both quotations
must be of the same maturity.]
One month quotation:
(CHF/INR) BID = (CHF/USD)BID x (USD/INR)BID
= 1 x (USD/INR)BID
(USD/CHF)ASK
1
= 1.3610 x 40.1275
= 29.4838

Schedules (Tables)
(CHF/INR) ASK = (CHF/USD)ASK x (USD/INR)ASK

1
= x (USD/INR)ASK
(USD/CHF)BID
1
= x 40.1375
1.3590
= 29.5346
One month quotation :

(CHF/INR) 29.4838 29.5346

Schedules (Tables)
Three month quotation:
(CHF/INR) BID = (CHF/USD)BID x (USD/INR)BID

= 1 x (USD/INR)BID
(USD/CHF)ASK
1
= 1.3555 x 40.2500
= 29.6938

Schedules (Tables)
(CHF/INR) ASK = (CHF/USD)ASK x (USD/INR)ASK

1
= x (USD/INR)ASK
(USD/CHF)BID
1
= x 40.2600
1.3535
= 29.7451
Three month quotation :
(CHF/INR) 29.6938 29.7451

Schedules (Tables)
3. from the above data determine quotation for
(a) 50days forward USD/INR
(b) 70 days forward USD/CHF and
(c) 70 days forward CHF/INR
one month = 30 days
(+) 30 days premium 0.0650 0.0700
30 days rate 4.1275 40.1375
(+) 20 days premium 0.0417 0.0417*

(a) 50 days quotation 40.1692 40.1792
* Proportional basis
Schedules (Tables)
**2 months = 60 days
(-) 60 days discount 0.0065 0.0055**
= 60 days rate 1.3560 1.3580
(-) 10 days discount 0.0008 0.0008*
(b) = 70 days quotation 1.3552 1.3572
(+) 60 days premium 0.1275 0.1325**
= 60 days rate 40.1900 40.2000
(+) 10 days premium 0.0200 0.0 200*
= 70 days quotation 40.2100 40.2200

Schedules (Tables)
The 70 days quotation for USD/INR and USD/CHF
when crossed would give:
70 days CHF/INR = 40.2100 -40.2200
1.3572 1.3552
70 days CHF/INR = 29.6272 29.6783 ----- (c)
Proportional discounts/premiums are calculated by using
formula
FM2 FM1X Required number of days.
SM2 SM1
FM1 = Forward margin of first (FM2 second) standard
maturity.
SM1 = First (SM2 second) standard maturity.
Schedules (Tables)
If forward margins of two consecutive maturities

change from premium to discount or vice versa use
the formula
FM2 + FM1 X Balance number of days.
SM2 SM1
4. Given spot USD/INR 48.8125 48.8175

One month forward 75 25
Two month forward 135 -185
Calculate USD/INR quotation for 40 days forward.

Schedules (Tables)
Spot USD/INR 48.8125 48.8175

(-) 30 days discount 0.0075 - 0.0025
= 30 days USD/INR 48.8050 48.8150
(+) 10 days premium 0.0070 - 0.0070*
= 40 days USD/INR 48.8120 48.8220
*Calculation of 10 days premium

(FM2 FM1)
X Balance number of days.
(SM2 SM1)
(135 + 75) X 10 = 70.
(60 30)
Schedules (Tables)
5. If the quotations provided in example # 1

(slide # 43) pertain to Bank X, then indicate the
rates at which deals would be done in response to
the following enquiries from other banks.
(a) Bank A wishes to purchase INR against USD 1 month
forward.
(b) Bank B wishes to purchase USD against CHF 2 months
forward.
(c) Bank C wants to sell INR against CHF 3 months
forward
(d) Bank D wants to sell USD against INR 50 days forward
(e) Bank E wants to sell CHF against INR 70 days forward.
Schedules (Tables)
(a) Quotations always pertain to the base currency. Bank

A wishes to purchase INR effectively means it wants to
sell USD. Therefore, Bank X would be a buyer USD 1
month forward and would quote : 40.1275.
(b) Bank B wishes to purchase USD means Bank X would

be a seller of USD 2 month forward and would quote :
1.3580
(c) Bank C wants to sell INR effectively means it wants to

buy CHF. Bank X would be a seller of CHF 3 months
forward and would quote : 29.7451

Schedules (Tables)
d) Bank D wants to sell USD therefore Bank X would be

buyer of USD 50 days forward and would quote:
40.1692
e) Bank E wants to sell CHF so Bank x would be a buyer
of CHF 70 days forward and would quote : 29.6272.
6. Given:
Spot USD/INR 46.0525 46.0575
Spot / August 425 475
Spot / September 1050 1100
Spot / October 1850 1900
Calculate quotations for 31 August, 30 September and 31
October. Foreign Exchange Calculations

Schedules (Tables)
Spot USD/INR 46.0525 46.0575

(+) Premium 0.0425 - 0.0475
31 August USD/INR 46.0950 46.1050
Spot USD/INR 46.0525 - 46.0575
(+) Premium 0.1050 - 0.1100
30 September USD/INR 46.1575 46.1675
Spot USD/INR 46.0525 - 46.0575
(+) Premium 0.1850 - 0.1900
31 October USD/INR 46.2375 46.2475
In premium situations forward margins are calculated to
the last day of the calendar month but in case of discounts
up to the first day of the month.

Schedules (Tables)
7. Given:
The following data on 4 October 2010.

Spot USD/INR 45.8030 80
Spot October 850 - 900
Spot November 1750 - 1800
Spot December 2680 2730
Calculate quotations for : a) 1 month 10 days forward and
b) 2 months 3 days forward.
a) The spot date on October 4 is 6 October 2010. 1 month

10 days forward would be 16 November 2010.
Schedules (Tables)
Spot USD/INR 45.8830 45.8880

(+) Premium 31 October 0.0850 0.0900
= 31 October USD/INR 45.9680 45.9780
(+) Premium for 16 days 0.0480 - 0.480
16 November USD/INR 46.0160 46.0260
Calculation of proportionate premium

6.5
b) The spot date on October 4 is 6 October 2010.
2 month 3 days forward would be 9 December, 2010
Spot USD/INR 45.8830 45.8880

(+) Premium 30 November 0.1750 0.1800
= 30 November USD/INR 46.0580
46.0680
(+) Premium for 9 days 0.0270 - 0.0270
9 December USD/INR 46.0850 *46.0950
December has 31
days
Calculation of proportionate premium

Schedules (Tables)
8. Given:
A bank in Mumbai is quoting
Spot USD/INR 45.0265 15
One month forward 485 535
Two month forward 985 1060
A Bank in New York is quoting
Spot USD/CHF 1.2190 - 00
One month forward 12 - 07
Two month forward 22 - 14
A customer of the bank in Mumbai wants to purchase CHF
against INR, two months forward. What rate would bank
quote?
Schedules (Tables)
Only the 2 months forward quotation required.
Spot USD/INR 45.0265 45.0315

(+) 2 month premium 0.0985 0.1060
2 month USD/INR 45.1250 45.1375
Spot USD/CHF 1.2190 - 1.2200

(-) 2 month discount 0.0022 - 0.0014
2 month USD/CHF 1.2168 - 1.2186

Schedules (Tables)
2 month forward quotation
( CHF/INR)ASK = (CHF/USD) ASK x (USD/INR) ASK Chain

rule
= 1 x (USD/INR) ASK Inverse rule

(USD/CHF)BID
1 = x 45.1375
1.2168
= 37.0952
The bank would quote 1CHF = INR 37.0952
(since the customer is a buyer, only selling rate is quoted)
Schedules (Tables)
9. Given:
Based on the following data; calculate 20 days forward
GBP/AUD quotation:
Spot GBP/USD 1.6636/45 USD/AUD
1.1803/13
I month forward 15/9 6/12
Spot GBP/USD 1.6636 1.6646
(-) 20 days discount 0.0010 0.0006
20 days forward 1.6626 1.6640
Spot USD/AUD 1.1803 - 1.1813

(+) 20 days premium 0.0004 - 0.0008
20 days forward 1.1807 - 1.1821
0
Schedules (Tables)
20 days forward quotation
(GBP/AUD)BID = (GBP/USD) BID x (USD/AUD) BID Chain

rule
= 1.6626 x 1.1807 = 1.9630
(GBP/AUD)ASK = (GBP/USD)ASK x (USD/AUD) ASK Chain

rule
= 1.6640 x 1.1821 = 1.9670
20 days forward GBP/AUD 1.9630 1.9670

Schedules (Tables)
GBP/USD Proportional discount, premium calculations:

Bid side Ask side
FM2 FM1 x D FM2 FM1 x D
SM2 SM1 SM2 SM1
= 15 0 x 20 = 10 = 9 0 x 20 = 6
30 0 30-0
USD/AUD
FM2 FM1 x D FM2 FM1 x D
SM2 SM1 SM2 SM1
= 60 x 20 = 4 = 12 0 x 20 = 8
30 0 30-0
AFM can be described as arithmetical difference

between the interest rates of the variable and base
currencies in annualized percentage terms.
Thus AFM = (Rv Rb). It is calculated as
FS 12 F Forward rate
AFM = x x 100 S Spot rate
S n
N Number of months
Unless otherwise specified, annualized forward margin

is conventionally calculated on the ask rates.

1. Given :
Spot USD/INR 40.0625 - 40.0675
3 month forward 40.2500 40.2600.
Calculate the annualized forward margin for USD/INR
quotation for three months. What is the significance of
your result?
AFM = F S x 12 x 100
S n
40.2600 40.0675 12
= x x 100
40.0675 3
0.1925 12
= x x 100 = 1.9218%
40.0675 3
The positive result indicates that the interest on INR >

interest rate on USD by 1.9218% for three months
maturity. One can, therefore, conclude that USD would
be at premium against INR.
Note: If annualized forward margin = 0, then it
indicates that Rv Rb = 0 which means that Rv = Rb
i.e. interest rates for both currencies are equal for the
given maturity. If AFM is negative, then it means that
Rv > Rb which means that the base currency would be
at a discount.
2. Given :
Spot GBP/SGD 2.6813
3 month AFM = Discount 1.50%
Calculate three months forward GBP/SGD rate.
AFM = F S x 12 x 100
S n
F 2.6813 12
(-) 1.50 = x x 100
2.6813 3
(-) 1.50 F 1.50 F
= -1 or 1 - = or
400 2.6813 400 2.6813
398.50 F 398.50 x 2.6813
= or F = = 2.6712
400 2.6813 400
3 months forward
Foreign GBP/SGD
Exchange rate
Calculations
3. Given :
4 months forward EUR/CHF rate = 1.5745
4 months forward AFM = (-) 2%
Calculate spot EUR/CHF rate.
AFM = F S x 12 x 100
S n
1.5745 - S 12
(-) 2 = x x 100
S 4
(-) 2 1.5745 2 1.5745
= -1 or 1 - = or
300 S 300 S
298 1.5745 1.5745 x 300
= or S = = 1.585
300 S 298
Spot
Foreign EUR/CHF
Exchange rate
Calculations
4. Given :
Spot USD/CAD 1.1305
6 month forward AFM = premium 1%
Calculate 6 month forward USD/CAD rate.
If CAD interest rate = 3.25 p.a., calculate USD interest
rate.
(F - S ) 12
AFM = x x 100
S n
F 1.1305 12
= x x 100
1.1305 6
1 F
=
200 1.1305
1 F
1+ =
200 1.1305
201 F
=
200 1.1305
F = 201 x 1.1305
200
F = 1.1362 = six months USD/CAD rate --
(1)
AFM = Rv Rb
1 = 3.25 - Rb
Rb = 3.25 1
= 2.25 = USD interest rate ------ (2)
5. Given :
Spot EUR/JPY 115.2000
3 month forward rate = 114.6950
Calculate AFM and interpret the result.
AFM = (F - S ) x 12 x 100
S n
114.6950 115.2000 12
= x x 100
115.2000 3
= (-) 0.5050 x 400
115.2000
= (-) 1.7535 3 month forward AFM __
(1) Foreign Exchange Calculations
The negative result indicates that base currency is at

discount.
Thus interest rate of base currency EUR is more than

interest rate of variable currency JPY by 1.7533% for
three months maturity.
------ (2)

6. Given :
A bank in India is quoting Spot USD/INR
44.8325 and is offering forward premium of 2%.
Calculate the banks 6 month forward USD/INR rate.
AFM = (F - S ) x 12 x 100
S n
F 44.8325 12
(+) 2 = x x 100
44.8325 6
1+ 2 = F
200 44.8325

202 = F
200 44.8325
F = 200 x 44.8325
202
F = 45.2828
Banks 6 month forward USD/INR rate : 45.2808

6.7 Relationship Between Exchange Rates , Interest Rates
and Commodity Prices
1. Purchasing Power Parity Theory (PPP)
The Law of One Price forms the basis for the

development of PPP theory. Gustav Cassel, a Swedish
economist, evolved this theory by applying the Law of
One Price to commodity markets. The theory states
that, The ratio of the price of a basket of goods and
services expressed in terms of the variable currency to
the price of the same basket expressed in terms of the
base currency should represent the spot exchange
rate between the two currencies.

In its absolute form, the theory can be represented as,
PV b
=S
Pb v
Where, Pv = price index in variable currency, Pb =
price index in base currency and S = Spot rate.
In most cases, this equality did not work because the

underlying assumptions were impractical.

By studying the relationship over a long period of time,

the following equality was established.,
Pv - Pb
S=
1 + Pb
Where, S = percentage change in the spot rate
over one year
Pv = percentage change in price index in variable
currency.
Pb = percentage change in price index in base
currency.
This relationship proved to be a reasonably accurate

estimation of the expected change in spot rate in
relation to the inflation rates (change in price index
effectively indicates inflation rate).
When this equality was studied for developed

economies having very small inflation rates, the
denominator, ( 1 + Pb) became approximately equal
to 1 and the equality was expressed as S= Pv -
Pb.

The theory, therefore, concluded that the rate of
change in the spot exchange rate between two
currencies was equal to the difference in their
corresponding inflation rates.
Effectively the rate of change in the spot rate = Iv Ib.
This theory has been used in developing currency
valuation system like the Crawling Peg mechanism.

Application of the theory: Crawling Peg Mechanism

When the flexible exchange rate system was
introduced in 1978, member countries of the IMF
were allowed to introduce independent currency
valuation systems. One of the mechanisms developed
and extensively used (mainly by the South American
countries) was the crawling peg mechanism.
These countries, initially, pegged their currencies to a
major international currency.

Application of the theory: Crawling Peg Mechanism

The peg would be reviewed and revised at the fixed
intervals based on the inflation rate difference
between the two currencies.
The system ensured that the change in the peg
reflected change in the countrys economy and also
prevented loss of reserve since it reduced the need for
the intervention for protecting the fixed peg.
The purchasing power of currency in the local
economy was reflected in the external value of the
currency.
2. Covered Interest Parity Theory (CIP)
The CIP theory is the financial market equivalent of

The Law of One Price
It states that When steps have been taken to
eliminate exchange rate risk, by fixing the forward rate
on the date of the transaction, then the cost of
borrowing in one currency is equal to the return on
financial investment in the other currency, irrespective
of the currency borrowed or currency of investment.

F 1 + Rb x n = S 1 + Rv x n
100 12 100 12
On simplification of equality, we get

F S = Rv Rb x n
S 100 12
When this equality holds good, there is no opportunity
for arbitrage. Since all variables are locked, risk less
profits can be earned and these are termed Covered
Interest Arbitrage.
Conclusion:
Interest theories as applied to
exchange rates help us to
conclude that the profit or
loss gained by the difference in interest
rates between two currencies is offset by
the profit or loss on account
of the difference between
the spot and forward
exchange rates.
3. Interest Rate Arbitrage

The equilibrium condition in terms of CIP theory is
represented by the relation
FS = Rv Rb x n
S 100 12
When this equality is satisfied, the cost of borrowing in
one currency is equal to investment yield earned on
the other currency. Therefore, we know, no arbitrage
opportunity exists.

3. Interest Rate Arbitrage

When this equality is violated, it provides opportunity
to earn arbitrage profit by borrowing in one currency
and investing in the other.
When F S > Rv Rb x n arbitrage profit is derived
S 100 12
by borrowing in variable currency and investing in base
currency. On the other hand
FS Rv Rb n
when < x arbitrage profit is derive
S 100 12
by borrowing in base & investing in variable currency.
4. Uncovered Interest Parity Theory
This theory is an extension of the CIP theory. It
presents the interest parity condition without the
forward rate being hedged. It assumes that the spot
rate on the forward date would be the same as the
forward rate on the spot date.
This assumption is not practical and hence the theory
is not actively used.
However, simplification of this equality helps to establish
S = Rv Rb; i.e. the rate of change in the spot rate between
two currencies is equal to the difference in their interest rates.
5. Fischers Theory on International Interest Rates
Irving Fischer combined the PPP theory and UIP theory
to arrive at
S = Pv - Pb ---- PPP theory
S = Rv Rb ---- UIP theory
Rv - Rb = Pv - Pb
Rv Rb = Iv Ib
Rv Iv = Rb Ib where R is nominal interest rate and
I, inflation rate.
The difference between the nominal interest rate and
the inflation rate for a given currency is defined as the
Real Rate of Interest.
5. Fischers Theory on International Interest Rates
This theory helps us to conclude that the real

ROI in all currencies is equal.
If there is an inequality, then international
funds would move into the currency
providing a higher real return.
The extra supply would eliminate the
inequality

1. Given
USD/CAD 1.620 spot
USD/CAD 1.1640 3 month forward
interest rate : USD - 4% p.a. ; CAD 5% p.a.
Identify and calculate interest rate arbitrage.
(F S) (1.1640 1.1620) 0.0020

= = = 0.0017 ---- (a
S 1.1620 1.1620
(Rv Rb) n (5 - 4) 3 1
x = x = = 0.0025 ---- (b)
100 12 100 12 400
Since (b) > ( a) we can derive arbitrage by borrowing in base
currency (USD) & investing in variable currency (CAD)
Assume borrowing USD 1 million for 3 months.

4 3
Cost of borrowing = 1,000,000 x x = USD 10,000
100 12
Benefit of investment :
Investment in CAD =
(1,000,000 x 1.1620) 1 + 5 x =1162000 x3
405
100 12
400
= CAD 1176525 or dividing by 1.1640
= USD 1010760.31 i.e. gain of 10760.31
Less cost of borrowing USD 10000
Arbitrage gain = USD 760.31
Foreign perCalculations
Exchange USD 1 million
2. Given
CHF 1.3615 per USD spot
CHF 1.3595 per USD 6 month forward
interest rate : CHF - 2% p.a. ; USD 4% p.a.
Identify and calculate interest rate arbitrage.
(F S) (1.3595 1.3615) 0.0020

= = = (-) 0.0015 --
S 1.3615 1.3615
(Rv Rb) n (2 - 4) 6 1
x = x = = (-) 0.0100 ---- (b)
100 12 100 12 100
Since (a) > (b) we can derive arbitrage by borrowing in variable
currency (CHF) & investing in base currency (USD)
Assume borrowing CHF 1 million for 6 months.

2 6
Cost of borrowing = 1,000,000 x x = CHF 10,000
100 12
Investment in USD =1000000 1.3615 = USD
734484
(734484) x 1 + x =1162000 x
4 6 204
100 12 200
= USD 749173.7 or multiplying by 1.3595
= CHF 1018501.65 i.e. gain of 18501.65
Less cost of borrowing CHF 10000
Arbitrage gain = CHF 8501.65 per CHF 1 million
3. Given
Spot USD = INR 44.3950
6 month forward 45.2400
Interest rate : INR - 7% p.a. ; USD 3% p.a.
Calculate possible arbitrage gain on 1 million of
capital.
(F S) (45.2400-44.3950) 0.8450
= = = 0.0190 -- (a)
S 44.3950 44.3950
(Rv Rb)x n = (7 - 3) x 6 = 2 = 0.0200 ---- (b)
100 12 100 12 100
Since (b) > (a) we can derive arbitrage by borrowing base
currency (USD) & investing in variable currency (INR)
Assume borrowing USD 1 million for 6 months.

3 6
Cost of borrowing = 1,000,000 x x = USD 15,000
100 12
Investment in USD=1000000x44.3950= in INR
44395000
(44395000) x 1 + x = 44395000 x
7 6 207
100 12
200
= INR 45948825 or dividing by 45.2400
= USD 1015668 i.e. gain of 15668
Less cost of borrowing USD 15000
Arbitrage gain = USD 668Exchange
Foreign per USD 1 million
Calculations
4. Given
USD/SGD 1.4815 1.4825 spot
USD/SGD 1.4840 1.4850 3 month forward
Interest rate : USD - 3% p.a. ; SGD 5% p.a.
Calculate arbitrage gain if any.
When two way quotations are given, it is not possible
to use the formula method, for identifying the currency
to be borrowed.
Case : # 1 Assume borrowing SGD 1 million. (INR)
5 3
Cost of borrowing = 10000000 x100 x12
= SGD 12500. ------ (1)
Investment in USD =SGD 10000001.4825= USD
674536
(674536) 1+ x = 674536 x
3 3 403
100 12 400
= USD 679595 or multiplying by 1.4840 = SGD

1008519
Thus there is net gain of SGD 8519 ----- (2)

Cost of borrowing > the net gain.
There is no arbitrage gainExchange

Foreign in investing in SGD.
Calculations
Case : # 2 Assume borrowing USD 1 million.

Cost of borrowing = 10000000 x 3 x 3
100 12
= USD 7,500. ------ (1)
Investment in SGD =1000000 x 1.4815
=SGD1481500
(1481500) 1+ x = 1481500 x
5 3 405
100 12 400
= SGD 1500019 or dividing by 14815. USD
1010113.64
Thus net gain USDForeign
10113.64 ---- (2)
Exchange Calculations
Arbitrage gain + 2,613.64 (2) less (1)
If there is a gain established

in case # 1,
it is not necessary to undertake
case # 2,
as arbitrage gain can be only
there in one situation.

5. Given
Spot GBP/SGD 2.6315 2.6325
GBP/SGD 2.6282 2.6292 6 month forward
Interest rate GBP: 3.60 3.80%. SGD 2.40%
2.60%
Calculate covered interest arbitrage.
Case : # 1 Assume borrowing GBP 1 million.
Cost of borrowing = 10000000 x x
3.80 6
100 12
= GBP 19,000. ------ (1)

Investment in SGD = GBP1000000 x 2.6315 =
2631500
SGD 2631500 1 + x = 2631500 x
2.40 6
202.40
100 12 200
= USD 2663078 or by 2.6292 = SGD 1012885
Thus there is net gain of SGD 12885 ----- (2)

Cost of borrowing > the net gain.
There is no arbitrage gainExchange

Foreign in investing in SGD.1 > 2
Calculations
Case : # 2 Assume borrowing SGD 1 million.

Cost of borrowing = 10000000 x 2.60x 6
100 12
= SGD 13000. ------ (1)
Arbitrageur can borrow at
the Ask rate & invest at the Bid rate.
Investment in SGD =1000000 2.6325 =GBP
379867
(379867) 1 + x = 379867 x
3.60 6
203.60
100 12
200
= SGD 386705 Foreign
or multiplying by 2.6282 GBP
1016337
(Based on CIP Theory)
1. Given
The following data was available to decide on the best
alternative for borrowing INR 12 million for a
temporary period of three months on a risk-free basis
(ignore transaction costs). Exchange rates against INR
Currency Spot Three Month Interest

Forward Rate
USD 40.1245 40.2765
4.25 p.a.
EUR 54.1650 54.2000 5.50
p.a.
GBP 80.0650 80.0350 6.00
Net liability when borrowing USD
12,000,000 x 1 + 4.25 x 3 x 40.2765 12,000,000

40.1245 100 12
= INR 173,441.50
Net liability when EUR
12,000,000 x 1 + 5.50 x 3 x 54.2000 12,000,000
54.1650 100 12
= INR 172,860.70
Net liability when borrowing USD
12,000,000 x 1 + 6.0 x 3 x 80.0350 12,000,000
80.0650 100 12
= INR 175,436.20
Borrowing in EUR is the cheapest
& best alternative.
2. Given
From the following data decide the best alternative for
investing INR 8 million for a temporary period of six
months on a risk-free basis (ignore transaction costs).

Forward Rates %
p.a.
INR 5.65
5.90.
USD/INR 48.8830 48.8860 49.2330 49.2360 4.25
4.50
EUR/INR 65.2545 - 65.2575 65.5545 65.5575 4.75
5.00 GBP/INR 90.4750 90.4780
90.6750 90.6780 5.25 5.50
Net return when investing in INR
8,000,000 x 1 5.65
+ x6 8,000,000
100 12
= INR 226,000
Net return when investing in USD
8,000,000 4.25 6
x 1+ x x 49.2330 8,000,000
48.8860 100 12
= INR 227,992
Net return when investing in EUR
8,000,000 4.75 6
x 1+ x x 65.5545 8,000,0
65.2575 100 12
= INR 227,274
Investment to be made
in USD where return is
Net return when investing in GBP maximum.
8,000,000 5.25 6
x 1+ x x 90.6750 8,000
90.4780 100 12
= INR 227,876*
* refer to notes
next.
Notes:
a) The amount to be invested in the foreign currency is
arrived at by dividing with the spot Ask rate because
this amount would be received from the bank on
delivery of the investible surplus in INR. The bank
would sell at the market Ask rate.
b) When interest rates are provided on two way basis, the
LHS rate represents the deposit rate and RHS rate
represents the lending rate. The accepting bank
therefore would give the deposit rate.
c) At the end of the specified period the maturity amount
in foreign currency would be sold to the bank at its
buying (Bid) rate.
3.
From the following data decide the best alternative for
borrowing INR 5 million for a temporary period of six
months on a risk-free basis (ignore transaction costs).

Forward Rates %
p.a.
INR 5.75
6.00.
USD/INR 48.8830 48.8860 49.2330 49.2360 4.25
4.50
EUR/INR 65.2545 - Foreign
65.2575 65.5545 65.5575
4.75
5.00 GBP/INR 90.4750 90.4780
Net return when borrowing in INR
5,000,000 x 1 + 6 6x 5,000,000
100 12
= INR 150,000
Net return when investing in USD
5,000,000 4.50 6
x 1+ x x 49.2360 5,000,000
48.8830 100 12
= INR 149,419
Net return when investing in EUR
5,000,000 5 6
x 1+ x x 65.5575 5,000,0
65.2545 100 12
= INR 148,797
Borrowing to be made in
EUR where liability is
Net return when investing in GBP minimum.
5,000,000 5.50 6
x 1+ x x 90.6780 5,000
90.4750 100 12
= INR 149,027*
* refer to notes
next.
Notes:
a) The amount to be borrowed in the foreign currency is
arrived at by dividing with the spot Bid rate because
this amount when sold to the bank would yield the
amount required to be borrowed. The accepting bank
would purchase at the market Bid rate.
b) When interest rates are provided on two way basis, the
LHS rate represents the deposit rate and RHS rate
represents the lending rate. The lending bank
therefore would charge the market lending rate.
c) At the end of the specified period the borrower would
be required to buy the maturity amount in foreign
currency at selling Ask rate.
Based on Uncovered Interest Parity Theory Concept
The carry of an asset can be described as the

difference between the appreciation in the asset (from
purchase to sale date) and the cost of holding the
asset. Such transactions in the Foreign Exchange
Market are called Currency Carry Trades. It involves
borrowing a currency with low interest /appreciation
rate to derive profit through the interest rate
differential.
Its a four step activity.

Its a four step activity.
1. Arrange borrowing in a low interest rate currency.
2. Convert to desired currency and acquire identified

asset.
3. Sell asset and reconvert funds to original currency.
4. Adjust loan obligation with interest.

A Carry trade transaction is not an arbitrage. As it does

not involve simultaneous buy-sell deals in two
different markets.
It represents a double speculation.
one that the benefit of appreciation of the
acquired asset (which may/may not happen)
second, this benefit would exceed the exchange
rate differential between the conversion and
reconversion dates and interest on borrowed
funds (which may/may not happen).
Carry trade transactions are popular with Japanese

Yen, as other than Swiss franc , it is the only major
currency that offers
capital account convertibility , and
very low interest rate for borrowing.
Japanese government prefers to maintain Yen

undervalued so as to ensure export competitiveness
to achieve surplus Balance of Trade.

1. Assume borrowing JPY 1000,000 @ 0.50% for a

year.
Convert JPY to GBP at spot rate GBP/JPY 208 and
Invest @ 4.5% for a year.
At the end of the year reconvert to JPY @ spot rate
GBP/JPY 221 = JPY 1,110,313
Profit on transaction JPY 1,110,313 1,005,000

= JPY 105,313 or approx. 10.5%
Out of this 4% is on account of interest rate
differential and balance on exchange rate differential.

2. Amount repayable at the end of a year JPY

1005,000
Convert JPY to GBP at spot rate GBP/JPY 208 and
Invest @ 4.5% for a year.
At the end of the year reconvert to JPY @ spot rate
GBP/JPY 200 = JPY 1,004,808
Loss on transaction JPY 1,005,000 1,004,808

= JPY 192
Profit of 4% on account of interest rate differential has
been wiped off by loss on account of exchange rate
differential.
Its evident that carry trade

to succeed, the currency to
be borrowed should have a
low interest rate AND
appreciative
tendency.
When DOW JONES WORLD
STOCK INDEX falls , the JPY
depreciates. This shows that
international traders use JPY Carry Trade process
to fund acquisition of securities when international
stock markets fall.

6.11 Summary
A forward exchange contract in foreign currency is a

contract for buying or selling a foreign currency for
delivery on a specified future date, at a rate of
exchange fixed at the time of entering the contract.
This contract reduces exchange rate risk faced by
importers and exporters.
Authorized Dealer can enter into forward contracts for
purchase of foreign currencies against goods exported
or to be exported against a firm order. Such contracts
can be made for exports orders in accordance with
schedule of deferred payments approved by the RBI.

6.11 Summary
Authorized Dealer can enter into forward contract for

sale of foreign exchange to importer provided Letter of
Credit is opened by the importer or firm order placed
by importer has been accepted by the supplier and the
import is covered by either the OGL (Open General
License) or valid import license.
Forward exchange rates are affected by factors like

interest rate differentials, confidence in the currency,
official intervention, exchange control regulations, and
attitude and fancies of foreign exchange dealers.

6.12 Self Assessment Questions
1. Discuss the connectivity between exchange rates ,

interest rates and commodity prices.
2. Explain PPP theory.
3. Elaborate CIP theory.
4. Bring about the features of Covered Interest
arbitrage
5. Express the rules involved in the Borrowing and
Investing decisions.

Thus we complete
chapter Six on
Foreign Exchange calculations
Good Luck !

Forward Rate Calculation

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Forward Rate Calculation

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International Finance

What is Forward Rate

6.2 Calculation of Forward Rates Through the Use

6.3 Calculation of Swap Points

6.4 Features of Forward Rates

6.5 Calculation of Forward Rates Through Schedules

6.6 Annualized Forward Margin (AFM)

6.7 Relationship Between Exchange Rates , Interest

6.8 Interest Rate Arbitrage

6.9 Borrowing and Investment Decisions

6.10 Japanese Yen Carry Trade

6.12 Self Assessment Questions

Foreign Exchange Calculations

Assume that a forward rate is required to be created

Liability at the end of one year would be:

The borrowed INR can be used to purchase 1 USD at

The USD available at the end of the year would be:

Therefore 1 year forward USD/INR

F = Forward rate. S= Spot rate

Foreign Exchange Calculations

In case rate is required in terms of days , then replace

In case days are in multiple of 30 the assume year to

Foreign Exchange Calculations

= 5.2425 x 406.5 x 400

Foreign Exchange Calculations

Foreign Exchange Calculations

Therefore (600 + Rb) = 1.3485 x 604

Foreign Exchange Calculations

Therefore swap points

For ask side swap points use deposit rate of Base

Foreign Exchange Calculations

For ask side swap points

Positive swap points represent premium on base

Foreign Exchange Calculations

Swap points are always

Factors are presented without positive or

It is understood that factors in ascending order,

Foreign Exchange Calculations

Spot USD/Cad 1.0985 1.0995

Three months USD/CAD 1.0999 - 1.1022

Foreign Exchange Calculations

Spot GBP/AUD 2.2950 2.2960

Six months GBP/AUD 2.2781 - 2.2847

(200 + Rv) = 202.00 Therefore Rv = 2.00

Foreign Exchange Calculations

(200 + Rb ) = 2.2960 x 202.25 = 203.25

Spot EUR/SGD 1.7480 1.7490

3 months EUR/SGD 1.7513 - 1.7544

Foreign Exchange Calculations

1.7480 EUR Lending

Foreign Exchange Calculations

Foreign Exchange Calculations

When forward rates are quoted by banks to their

Foreign Exchange Calculations

Spot USD/INR 41.0625 Spot USD/CHF 1.3625 1.3635

1 month forward 650 -700 1 month forward 35 25

2 month forward 1275-1325 2 month forward 65 55

3 month forward 1875 -1925 3 month forward 90 80

6 month forward 3650 - 3700 6 month forward 165 - 155

Foreign Exchange Calculations

In a given schedule of forward margins if, LHS

In a given schedule of forward margins, LHS factors

Foreign Exchange Calculations