When it comes to international business, the use of foreign currency forward contracts is becoming increasingly common. These contracts allow businesses to hedge against the risk of fluctuations in exchange rates, ensuring they can accurately budget and forecast costs and revenues.

However, determining the fair value of a foreign currency forward contract can be a complex process. In this article, we’ll explore what fair value means and how it is calculated for foreign currency forward contracts.

What is fair value?

The fair value of an asset or liability is the price at which it could be sold in an orderly transaction between knowledgeable, willing parties. This definition is important because it provides an objective measure of value that can be used for financial reporting purposes.

In the case of foreign currency forward contracts, fair value is determined by the difference between the contract rate and the current spot rate for the same currency pair. The contract rate is the agreed-upon exchange rate at which the transaction will occur at some point in the future, while the spot rate is the current market rate for that currency pair.

Calculating fair value

To calculate the fair value of a foreign currency forward contract, you need to follow these steps:

1. Determine the contract rate: This is the exchange rate agreed upon in the contract. It is usually quoted as the number of units of the foreign currency that can be bought or sold for one unit of the domestic currency.

2. Determine the spot rate: This is the current market rate for the currency pair. It can be found on financial news websites or through currency exchange services.

3. Calculate the forward points: This is the difference between the contract rate and the spot rate, expressed in pips (percentage in point). For example, if the contract rate is 1.2000 and the spot rate is 1.1500, the forward points would be 500 pips.

4. Convert forward points to the amount in the domestic currency: Multiply the forward points by the notional amount (the amount of currency being exchanged) and divide by 10,000. For example, if the notional amount is $100,000 and the forward points are 500, the amount in the domestic currency would be $50 ($100,000 x 500/10,000).

5. Add the amount in the domestic currency to the contract rate: This gives you the fair value of the foreign currency forward contract. For example, if the contract rate is 1.2000 and the fair value in the domestic currency is $50, the fair value of the contract would be 1.2050.

Conclusion

Determining the fair value of a foreign currency forward contract is an important aspect of financial reporting for businesses that engage in international trade. By following the steps outlined above, businesses can accurately calculate the fair value of their contracts and ensure that their financial statements are reflective of their true value.