Forex Forward Contracts

Oct 21, 2021 04:14 PM ET
Forex Forward Contracts

In the forex market, a forward contract is a binding agreement whereby a party commits to buy or exchange a particular currency for another on a specific date, usually within a year, at a price that has been agreed upon now. The contractual price of exchange is referred to as a forward rate.

When you agree on a forward rate today, you agree to use that exchange rate in the future to transfer your currency. With the spot rate as your starting point, you can change it based on the amount of time left until the transfer and currencies to be converted. Forward rates don't have to match up with actual exchange rates.

By using forwards, you are reducing your sensitivity to currency swings and FX rate shifts. For businesses that must control their cash flow and keep it predictable, locking in rates today allows you to plan ahead with confidence, knowing what your exact costs will be for purchasing and selling internationally.

How do forward contracts work?

Because the contracts aren't conventional, any amount can be agreed upon. They are obligations to buy or sell a predetermined amount of currency at a predetermined exchange rate and at a set time. 

There are two types of forward contracts in the FX market: "open" and "closed." In contrast to closed contracts, which must be settled in full on a specific date, open forward contracts provide a time range during which all or part of a contract can be paid. FX forwards eliminate the need for overnight funding charges but come with bigger spreads when it comes to opening positions than spot forex markets offer.

Forwards are also an effective way for hedging other open FX positions. When using forward hedging, you open a contract to cover the risk of current trade, such as a spot forex position that has not yet closed. Selling a forward contract, for example, is a common way to protect oneself from a currency's fluctuation.

In forwards, on the agreed-upon day, the buyer must pay the seller the amount that they have agreed on in exchange for the predefined quantity of assets. Consequently, sellers gain money on downturns, while buyers lose money when spot prices are higher than agreed-upon forward prices. As a result, as an alternative approach, instead of actually exchanging currencies, the two parties could simply agree on a loss or profit figure.

The fact that each contract has a particular delivery or fixing date makes them more suitable for hedging the potential FX risk on a single principal repayment rather than multiple repayments of principal and interest rates. If used to hedge a loan's foreign exchange risk, forwards are preferred over swaps since they are more economical, though less effective. This leaves interest payments unprotected.

A real-world illustration

Consider a scenario in which a US corporation intends to sell a German firm €10 million worth of items and get the payment within a year. A rise in the dollar's value against the euro would lower the value of exports from the United States. Therefore, the US corporation locks in a rate of $1 = €0.85 and protects its profits by selling €10 million in FX forwards over the next year.

The corporation will profit from the contract if one year from now the spot price of one dollar rises to €1.00. However, they may lose money if the dollar falls to €0.75 because it will receive fewer dollars in exchange for the euros compared to the prevailing spot rate.

Forward contract calculation

  • To compute the forward rate, a system will use the market spot rate and an adjustment known as a 'forward point.
  • When determining forward exchange charges, the difference between the interest rates of the currency pair and the time to maturity is taken into account.
  • Forward points are calculated using a standard method that is accepted throughout the industry.
  • An agreement is reached after the currencies have been matched and the volume of transaction and the accepted exchange rate have been established.

Key takeaways

  • Trading FX forwards always involves dealing in a currency pair 
  • Currency forwards can be used to protect other FX trading positions.

Advantages

  • Assures the buyer of the cost of a future currency acquisition.
  • It's possible to customize an FX forward to meet a client's specific needs.
  • They help reduce the amount of anxiety you feel from having to keep up with everyday changes in the foreign exchange market.
  • Future volatility can be managed effectively using this risk management tool.
  • They're excellent instruments for keeping your account's liquidity protected.

Disadvantages

  • Clients are obligated to uphold their end of the bargain and cannot take advantage of favorable changes in currency exchange rates.
  • Margin requirements may hurt the borrower's cash flow if the market moves against the client or broker.

In summary

An FX forward contract is a way of covering one’s position or business from potential unfavorable fluctuations in the future. It is an effective way to hedge one’s exposure to the unknowns that come with the volatility of FX markets and can, therefore, be used for effective budgeting and planning by traders, investors and companies. Overall, forex hedging strategies should include using forwards to minimize risk exposure.


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