Calculation of Fixed and Option forward rates, Inter bank deals

The calculation of fixed and option forward rates is based on the current spot exchange rate between two currencies and the interest rate differentials between the two currencies.

Calculation of Fixed Forward Rates:

The fixed forward rate is determined by adding or subtracting the interest rate differential between the two currencies from the current spot exchange rate. The formula for calculating the fixed forward rate is:

Fixed Forward Rate = Spot Exchange Rate +/- Interest Rate Differential

For example, suppose the current spot exchange rate between USD and EUR is 1.20 and the interest rate in the US is 2% while in the Eurozone it is 1%. The fixed forward rate for a one-year contract would be:

Fixed Forward Rate = 1.20 + (1.0% – 2.0%) = 1.18

This means that in a one-year contract, one Euro can be exchanged for 1.18 USD.

Calculation of Option Forward Rates:

Option forward rates are calculated using complex mathematical models that take into account factors such as the volatility of the currency pair, time to expiration, and strike price. Option forward rates are typically quoted as a premium over the fixed forward rate.

Interbank deals involve the trading of currencies between banks at the interbank rate. The interbank rate is the wholesale exchange rate at which banks buy and sell currencies from each other. The interbank rate is determined by the supply and demand for each currency in the market and can vary from day to day or even hour to hour.

In interbank deals, banks can trade fixed and option forward contracts with each other, allowing them to manage their foreign exchange risks and take advantage of market opportunities. The terms of the contract, including the amount, currency pair, exchange rate, and settlement date, are negotiated between the parties. Interbank deals are typically settled in cash or by physical delivery of the currencies involved.

Execution of Forward Contracts

The execution of a forward contract involves a few key steps:

Negotiation of Terms: The parties involved in the forward contract negotiate the terms of the contract, including the currency pair, the exchange rate, the notional amount, the settlement date, and any other relevant details.

Agreement on Terms: Once the terms of the contract are negotiated, both parties agree to the terms and sign a contract.

Payment of Margin: In order to secure the forward contract, the buyer is typically required to make a payment of margin to the seller. The margin is usually a percentage of the notional amount and is intended to protect the seller against losses if the buyer defaults on the contract.

Settlement: On the settlement date, the buyer pays the agreed-upon amount of the currency at the agreed-upon exchange rate to the seller, and the seller delivers the currency to the buyer.

It’s important to note that forward contracts are non-standardized and are typically negotiated between the parties involved. As a result, there is no centralized exchange for trading forward contracts, and the terms of the contract can vary widely.

Forward contracts can be settled in cash or through physical delivery of the currencies involved, depending on the terms of the contract. However, physical delivery is less common than cash settlement because it requires the actual exchange of currencies and can be logistically complex.

Overall, the execution of a forward contract requires careful negotiation and agreement on the terms of the contract to ensure that both parties understand their obligations and risks.