Many corporations and some high-net-worth individuals use currency forward contracts to hedge their future or forward currency exposures to the forex market against unfavorable moves. Companies with international currency risk typically hedge to help stabilize the domestic value of their foreign currency cash flows or investments.
Forward contracts trade in the over-the-counter FX market rather than on an exchange. Other names for a currency forward contract include a forward outright and an FX forward.
If you’re interested in finding out more about currency forward contracts, then read on.
What is a Currency Forward?
In the foreign exchange market, a currency forward or forward outright contract involves a binding agreement between two counterparties where one agrees to buy and the other to sell a set amount of one currency versus another at an agreed-upon rate of exchange or “exchange rate” for delivery on a future delivery date that is generally different from the current spot value date.
FX forwards trade in the over-the-counter or OTC forex market, so their terms can be customized. For example, a counterparty can select a currency pair, a notional amount and/or a delivery date for the contract that suits their particular needs.
The forward rate for a particular currency pair and value date depends on the prevailing spot rate, the length of time until delivery and the interest rate differential between the two currencies involved.
How Does a Currency Forward Work?
Currency forward contracts generally settle on a day beyond or forward of the current spot value date. A forward contract’s forward outright exchange rate must therefore take into account the interest rate differential between the two currencies. This requires knowing the Interbank deposit interest rates for each currency pertaining to the value date of the forward contract.
Unless those deposit interest rates are the same for each currency, the interest rate differential will benefit the counterparty holding the higher interest rate currency over the term of the forward contract.
The counterparty holding the currency with the lower interest rate must compensate the other party to the currency forward contract by paying the difference between the interest rates over the duration of the contract. This difference and the prevailing spot exchange rate are fed into a standard formula to derive the FX forward outright’s exchange rate.
The difference in pips between the spot and forward outright exchange rates is known as swap points. These swap points are quoted by forex forward desks to their clients so that the swap points can be easily added to or subtracted from the prevailing spot rate, as appropriate, to compute the forward outright rate.
How Do You Calculate a Forward Rate?
You can determine the forward outright rate for a currency forward contract for a given value date using this formula:
F= S[(1 + ib)/ (1 + ic)]
F = the forward outright rate for the currency pair
S = the spot exchange rate for the same pair
Ib = the base currency Interbank deposit interest rate for the given future value date
ic = the counter currency Interbank deposit interest rate for the given future value date
However, since the delivery date of a currency forward is often not an entire year in the future and Interbank deposit interest rate quotes are generally annualized, you will usually need to convert those annualized rates to fractional year interest rates to use the equation above. You can do that conversion using this formula:
if = ia x (Dv/Dy)
if = fractional year interest rate
ia = annualized interest rate
Dv = the number of days until the forward contracts’ value date
Dy = the number of days in a year
If you want to determine the swap points that apply to a particular value date for a currency pair, you need to compute the difference in pips between F (the forward outright rate that was computed in the preceding equation) and S (the prevailing spot rate for the currency pair). You can use this formula to do that:
Swap points= F - S
Once you know or are quoted the swap points for a given value date, you can readily calculate the forward rate for delivery on that date given a spot rate quote. If you are a client to a market maker, then remember that you will be buying (selling) the base currency outright at the offer (bid) side of the quoted spot rate and swap points.
What is the Difference Between Currency Forwards and Currency Futures?
The main difference between currency forwards and currency futures is that forwards are customizable and trade in the OTC forex market while currency futures trade on exchanges like the Chicago Mercantile Exchange (now part of the CME Group) and are standardized in terms of their notional amount and value dates.
Example of a Forward in Forex Trading
In practice, forwards are generally transacted by trading the desired notional amount for value spot after first getting a quotation for the swap points from a forward desk for the desired forward value date. The spot position is then rolled out to the forward date and the exchange rate is adjusted by the quoted number of swap points.
For example, forwards are often used by corporations looking to hedge a known foreign currency exposure against adverse exchange rate movements. The best type of forex exposures to hedge with a currency forward are known in their amount and their date. Forwards can be transacted in custom amounts and value dates running out to 10 years.
As an example of how a forward might be used, consider the situation of a Canadian corporation that has signed a contract in U.S. dollars for goods from a U.S.-based supplier. The terms of the contract specify that they will need to pay $10 million U.S. dollars to the supplier in three months’ time.
To protect against adverse moves in the USD/CAD exchange rate, the corporation’s financial department decides to execute a forward transaction to buy the $10 million with Canadian dollars in advance and roll it out for three months so that it can be delivered per the currency contract.
They call up a commercial bank they have a good relationship with and ask for an offer on a three-month USD/CAD currency forward in $10 million. The bank’s USD/CAD forex dealer quotes the offer side for the USD/CAD spot exchange rate of 1.3200, and the bank’s forward desk quotes the offer side for the three-month swap points of 5 pips or 0.0005 for that amount.
If transacted at those quotes, the all-in exchange rate for the three-month forward the Canadian corporation needs would be (1.3200 + 0.0005) = 1.3205.
Note that since the Canadian dollar currently pays a higher rate of interest rate than the U.S. dollar, the Canadian dollar trades at a forward discount to the U.S. dollar. Also, because the forward rate is just computed based on the current deposit interest rate differential pertaining to the forward value date, it does not incorporate a market view regarding the future level of the USD/CAD exchange rate on that date.
Forex Forwards and Hedging
The example in the previous section uses a very common FX forward hedging scenario to illustrate how a corporation might use a forex forward to hedge against a known future forex exposure.
This is one of the most popular applications in the forward market, and corporations engaged in the international trade of goods and in offering services to foreign companies often use forwards to hedge their known foreign currency exposures in this manner.
Furthermore, international companies often have foreign offices or subsidiaries that incur substantial operating costs. The budgeted amounts of these foreign costs are often hedged in advance by the head office once they are projected by management.
This prudent hedging practice allows a company’s head office to buy the projected necessary amount of foreign currency with its domestic currency in advance to pay in foreign currency for the projected operating expenses that its foreign operations will need in the future using a futures contract.
Trade Forwards with These Top Forex Brokers
Benzinga has helped take the guesswork out of finding a reputable online forex broker by compiling the following table of top forex brokers.
Frequently Asked Questions
Can you sell a currency forward?
Yes, you can sell one currency in exchange for another currency for a value date in the future if you can trade in the over-the-counter forex market.
Is a currency forward a security?
No, a currency forward is instead an over-the-counter contract traded in the forex market that allows you to lock in an exchange rate for a future delivery date.
Are forward contracts risky?
Yes. They are about as risky as a spot transaction with respect to the resulting exposure to exchange rate fluctuations. Forward contracts can also be used to hedge existing forex exposures.
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