Currency Forward

What Is a Currency Forward?

A currency forward is a binding contract in the foreign exchange market that locks in the exchange rate for the purchase or sale of a currency on a future date. A currency forward is basically an adaptable hedging device that doesn't include an upfront margin payment.

The other major benefit of a currency forward is that its terms are not normalized and can be tailored to a specific amount and for any maturity or delivery period, dissimilar to exchange-traded currency futures.

Understanding Currency Forwards

Not at all like other hedging mechanisms, for example, currency futures and options contracts — which require an upfront payment for margin requirements and premium payments, separately — currency forwards regularly don't need an upfront payment when utilized by large corporations and banks.

Notwithstanding, a currency forward has little flexibility and addresses a binding obligation, and that means that the contract buyer or seller can't walk away if the "locked-in" rate at last ends up being adverse. Therefore, to make up for the risk of non-delivery or non-settlement, financial institutions that deal in currency forwards might require a deposit from retail investors or more modest firms with whom they don't have a business relationship.

Currency forward settlement can either be on a cash or a delivery basis, given that the option is mutually acceptable and has been determined in advance in the contract. Currency forwards are over-the-counter (OTC) instruments, as they don't trade on a centralized exchange, and are otherwise called "out and out forwards."

Merchants and exporters generally use currency forwards to hedge against variances in exchange rates.

Illustration of a Currency Forward

The mechanism for computing a currency forward rate is straightforward, and relies upon interest rate differentials for the currency pair (expecting the two currencies are uninhibitedly traded on the forex market).

For instance, expect a current spot rate for the Canadian dollar of US$1 = C$1.0500, a one-year interest rate for Canadian dollars of 3 percent, and the one-year interest rate for US dollars of 1.5 percent.

Following one year, in view of interest rate parity, US$1 plus interest at 1.5 percent would be equivalent to C$1.0500 plus interest at 3 percent, meaning:

• $1 (1 + 0.015) = C$1.0500 x (1 + 0.03)
• US$1.015 = C$1.0815, or US$1 = C$1.0655

The one-year forward rate in this example is subsequently US$ = C$1.0655. Note that in light of the fact that the Canadian dollar has a higher interest rate than the US dollar, it trades at a forward discount to the greenback. Also, the real spot rate of the Canadian dollar one year from now has no correlation on the one-year forward rate as of now.

The currency forward rate is just in view of interest rate differentials and doesn't incorporate investors' expectations of where the genuine exchange rate might be from here on out.

Currency Forwards and Hedging

How does a currency forward function as a hedging mechanism? Expect a Canadian export company is selling US$1 million worth of goods to a U.S. company and hopes to receive the export proceeds a year from now. The exporter is worried that the Canadian dollar might have strengthened from its current rate (of 1.0500) a year from now, and that means that it would receive less Canadian dollars per US dollar. The Canadian exporter, therefore, goes into a forward contract to sell $1 million per year from this point at the forward rate of US$1 = C$1.0655.

Assuming that a year from now, the spot rate is US$1 = C$1.0300 — and that means that the C$ has appreciated as the exporter had anticipated - by locking in the forward rate, the exporter has benefited to the tune of C$35,500 (by selling the US$1 million at C$1.0655, rather than at the spot rate of C$1.0300). Then again, on the off chance that the spot rate a year from now is C$1.0800 (for example the Canadian dollar debilitated in opposition to the exporter's expectations), the exporter has a notional loss of C$14,500.

Features

• Dissimilar to listed currency futures and options contracts, currency forwards don't need up-front payments when utilized by large corporations and banks.
• They are generally utilized for hedging, and can have redone terms, like a specific notional amount or delivery period.
• Deciding a currency forward rate relies upon interest rate differentials for the currency pair being referred to.
• Currency forwards are OTC contracts traded in forex markets that lock in an exchange rate for a currency pair.

FAQ

What Is the Difference Between Currency Forwards and Currency Futures?

Currency forwards and futures are basically the same. The primary difference is that currency futures have normalized terms and are traded on exchanges, for example, the Chicago Mercantile Exchange (CME), while forwards have adaptable terms and are traded over-the-counter (OTC).

Which Currencies Can Currency Forwards Be Written on?

Since they are adjustable and trade OTC, currency forwards can show up on quite a few currency pairs. Which ones not entirely settled by the counterparties engaged with the trade.

Why Are Currency Forwards Used?

Currency forwards are utilized to lock in an exchange rate for a certain period of time. This is frequently used to hedge foreign currency exposure