Foreign exchange short dates are forward contracts that expire in less than one year. A forward contract is an agreement between two parties to exchange a certain amount of currency at a fixed rate on a specified future date. Forward contracts are used to hedge against the risk of exchange rate fluctuations or to speculate on future market movements.
In forex trading, a short dated forward typically involves trading a currency at a specified spot date that is before the normal spot date, ranging from one week to one month after the trade date1. The spot date is the date when the currency exchange takes place, usually two business days after the trade date. For example, if a trader buys EUR/USD at a spot rate of 1.20 on Monday, January 1, 2024, the spot date would be Wednesday, January 3, 2024. However, if the trader wants to lock in the exchange rate for a future date that is before the spot date, they can use a short dated forward contract. For instance, they can buy EUR/USD at 1.20 for delivery on Tuesday, January 2, 2024, which is one day before the spot date. This is a short dated forward contract with a tom next (tomorrow next) settlement, meaning the contract expires the next business day.
Short dated forward contracts are less risky than long dated forward contracts, which have maturities longer than one year, because there is less chance of default or adverse market movements within a shorter time frame. Short dated forward contracts also have lower bid-ask spreads, which means they are cheaper to execute. Short dated forward contracts are useful for traders and investors who want to maintain their positions without taking physical delivery of the currency or who want to take advantage of short-term opportunities in the forex market.
Basic Theory:
Foreign exchange rates fluctuate constantly due to various economic factors. A short date in Forex refers to a specific date within a larger time frame, typically less than a year. Calculating exchange rates for short dates involves understanding the concept of forward rates. Forward rates are the future exchange rates agreed upon today for a transaction that will take place in the future.
Procedures:
To calculate the foreign exchange rate for a short date, you can use the formula:
Forward Rate = Spot Rate * (1 + ((Domestic Interest Rate - Foreign Interest Rate) * (Days / 360) / 100))
Where:
- Spot Rate: Current exchange rate.
- Domestic Interest Rate: Interest rate of the domestic currency.
- Foreign Interest Rate: Interest rate of the foreign currency.
- Days: Number of days to the short date.
Comprehensive Explanation:
Let’s break down the formula step by step:
- Spot Rate: The starting point is the current exchange rate between the two currencies.
- Interest Rate Differential: The difference between the interest rates of the two currencies.
- Days: The number of days to the short date is considered. The division by 360 is a common convention in financial markets.
- Calculation: Multiply the interest rate differential by the number of days and divide by 360. Add 1 to this result and multiply by the spot rate to get the forward rate.
Real-world Scenario:
Suppose we have the following scenario:
| A | B | |
|---|---|---|
| 1 | Spot Rate | 1.20 |
| 2 | Domestic Interest Rate | 2% |
| 3 | Foreign Interest Rate | 1.5% |
| 4 | Days to Short Date | 90 |
| 5 | Forward Rate Formula | =B1*(1+((B2-B3)*B4/360)/100) |
The result in cell B5 will be the forward exchange rate.
Result:
Forward Rate = 1.20 * (1 + ((2% – 1.5%) * 90 / 360 / 100)) ≈ 1.2045
Therefore, the calculated forward rate is approximately 1.2045.
Other Approaches:
- Excel’s RATE Function: Use the RATE function in Excel, which calculates the interest rate for a fully invested security, to indirectly calculate the forward rate.
- Data Tables: Utilize Excel’s Data Table feature to perform sensitivity analysis on the forward rate by varying the interest rates and days.
