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Forward Contract Pricing

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Forward Contract Pricing

The pricing of forward contracts involves determining the forward exchange rate at which two parties agree to exchange currencies at a future date. The forward rate is influenced by several factors, including the current spot rate and interest rate differentials.

The general process for pricing a forward contract is as follows:

Determine the Spot Rate: The spot rate is the current exchange rate between the two currencies. It represents the rate at which currencies can be exchanged immediately.

Consider Interest Rate Differentials: The forward rate is influenced by the interest rate differentials between the two countries involved in the currency pair. The interest rate differential reflects the cost of borrowing one currency and lending the other over the specified time-period of the forward contract. Higher interest rates in one country relative to another typically lead to a higher forward exchange rate for the currency of the higher interest rate.

Calculate the Forward Rate: The forward rate is calculated based on the spot rate and the interest rate differentials and will incorporate some commercial margin for the principal party.

The forward rate represents the exchange rate at which the two parties agree to exchange currencies on the settlement date of the forward contract or over a period to a settlement date.

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