Forward Pricing Logic
You want to buy $1 after a year, and you are afraid that its price will boil from EGP 20 today to a price you do not know after a year.
There is a very simple solution…
First, the data
– Borrowing rate in EGP = 15%
– The interest rate on the dollar deposit = 4%
– The current exchange rate = EGP 20 to the dollar
Second, the steps
1. Borrow EGP 19.2 today at an interest rate of 15% for a year
2. About EGP 19.2 for 96 cents (at the exchange rate of 20)
3. Deposit the 96 cents in the bank for one year at 4%, and you will have the $1 you want.
4. After a year, you will pay off EGP 22.1 EGP = the original EGP 19.2 loan + 15% interest
A year later, I bought 1 dollar for 22.1 pounds, but this price you knew in advance because it depended on interest rates.
This is the forward price of the dollar, and the exact same price you will get if you make the calculation that is used in calculating the forward rate in major banks:
USD/EGP FWD =
USD/EGP SPOT X (1 + 15%)/(1 + 4%) =
20 X 1.106 = 22.1
In the previous story, what actually happened was that 96 cents were stored for a year and the storage cost was 15% (the interest of the Egyptian pound loan) and this is known as the cost of carry.
But, during the year, 96 cents increased by 4 cents because its convenience yield, and the convenience yield actually cut storage costs from 15% to about 11%.
So, two conclusions:
1. The forward rate of the dollar = the current price multiplied by (1 + interest rate in Egypt) divided by (1 + interest rate in America).
2. As long as the interest on the EGP is higher than the interest on the dollar, the forward price of the dollar will remain higher than the current price and this is based on an equation and not a prediction.
