Forward exchange contracts and Effective Interest Rate

1. Knowledge Circle
Effective interest rate, Forward exchange contracts

2. Effective Interest Rate
• A way of restating the Annual Interest rate such that it takes into
account the effects of compounding
R = (1+i)n/n -1
R = Effective Annual Rate of Interest
i = Stated Annual Interest Rate
n = Compounding Period

3. Example : Savings A/c
• i = 10%
• n = 12
R = (1+10)12/12 -1
R = 10.471 %
Compounded Monthly Compounded Annually
1000 x 10.471% = $104.71
R = 10 %
1000 x 10% = $100
Advertised Interest Rate = 10%

4. Effective Interest Rate
• The effective annual interest rate is the real return on a savings
account or any interest-paying investment when the effects of
compounding over time are taken into account.
• It also reveals the real percentage rate owed in interest on a loan, a
credit card, or any other debt
• Also called the effective interest rate, the effective rate, or the annual
equivalent rate

5. Forward Exchange Contracts
• A forward exchange contract is an agreement under which a
business agrees to buy a certain amount of foreign currency on a
specific future date.
• The purchase is made at a predetermined exchange rate
Forward rate = S x (1 + r(d) x (t / 360)) / (1 + r(f) x (t / 360))
Forward exchange rates for most currency pairs can be
obtained for up to 12 months in the future

6. Forward Exchange Contracts
• The forward exchange rate for a contract can be calculated using four
variables:
• S = the current spot rate of the currency pair
• r(d) = the domestic currency interest rate
• r(f) = the foreign currency interest rate
• t = time of contract in days
Forward rate = S x (1 + r(d) x (t / 360)) / (1 + r(f) x (t / 360))

7. Example
• For example, assume that the U.S. dollar and Canadian dollar spot rate
is 1.3122. The U.S. three-month rate is 0.75%, and the Canadian three-
month rate is 0.25%. The three-month USD/CAD forward exchange
contract rate would be calculated as:
• Three-month forward rate = 1.3122 x (1 + 0.75% * (90 / 360)) / (1 +
0.25% * (90 / 360)) = 1.3122 x (1.0019 / 1.0006) = 1.3138
$10000
Present Amount
$13138
Buying Amount (3 months)
x 1.3138