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Forward exchange contracts and Effective Interest Rate

Effective interest rate takes compounding into account to show the actual return on an investment over time. It is calculated using the stated annual interest rate and compounding period. For example, a 10% annual interest savings account compounded monthly earns an effective 10.471% annually. A forward exchange contract is an agreement to buy a set amount of foreign currency at a predetermined future exchange rate. The forward rate can be calculated using the current spot rate, domestic interest rate, foreign interest rate, and the number of days until settlement. For example, a 3-month USD/CAD contract rate would be 1.3138 using given spot and interest rates.

Economy & Finance◦
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Knowledge Circle Effective interest rate, Forward exchange contracts
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
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%
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
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
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))
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