Interest rates, swap rates and forward rates

Many people, even in the financial sector think that a forward rate is an expectation or forecast of a future foreign exchange movement. This is a big mistake. Actually, a forward rate is nothing else but a mirror of the currently prevailing spot rate, allowing for the interest rate differential between the two currencies and the time period at the expiration of which the actual transaction will be concluded. So the spot rate is adjusted by the so called swap rate to give the forward rate. For the unsophisticated investor it is enough to say that the swap rate is there to compensate the low interest currency holder for the time period involved in a forward transaction. The best way to explain these strange sounding terms is an example. We shall keep the simplistic approach and will not get involved here with FX rate spreads and interes rate spreads. Suppose person X buys $ 100,000 against Dmarks from bank B at spot rate 1.5000 for value 30 days forward. Furthermore let us assume that the dollar interest rate for this period is 5% and for the mark 3%. This means that during these 30 days A will earn interest on the marks he keeps until delivery and B will earn interest on the dollars for the same reason. The forward rate must allow for the compensation of A so that on balance no party is better or worse off. Investor A will receive interest in marks= (150,000x3x30)/36,000 = 375. On the other hand bank B will receive interest in dollars = (100,000x5x30)/36,000 = 416.67. This dollar amount calculated by prevailing spot rate 1.5000 is equivalent to 625 marks. It is evident that bank B has to compensate investor A through the forward rate, i.e. A will pay a lower price for the dollars he is buying forward to equalise the difference of 250 marks. Through a formula we can reach the swap rate 0.0025 This is subtracted from 1.5000 and the forward rate 1.4975 prevails. Indeed, the investor will finally deliver 149,750 marks to receive 100,000 dollars.