Richard wants to deposit EUR1000 for 3 months starting in 3 months time, what would the forward rate be ?
The EUR 3 month forward interest is 13.0%
The EUR 6 month forward interest is 13.1%
The forward rate would be 12.79%
Richard is also exposed to interest rate risk
If interest rates go up before the start date then Richard will be worse off.
Hedging the Interest Rate Risk
The bank that Richard has deposited his cash with is now exposed to interest rate risk
If interest rates go down before the start date then the bank will be worse off.
If the bank wanted to hedge this interest rate risk then it could sell a Forward Rate Agreement.
Steven goes to a bank and agrees to deposit £10,000 for 3 months starting in 6 months time.
The bank agrees to pay him £10,900 in nine months time.
The forward rate would be ( (10900 / 10000) - 1 ) = 9%
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