Currency Forward

A forward contract is a customized agreement between two parties to carry out a transaction at a specified future date. The parties establish the price and date for purchasing (or selling) an asset today. The buyer assumes the “long” position, while the seller takes the “short” position. The price agreed upon is referred to as the delivery price. FX Forwards are particularly useful for businesses looking to hedge against foreign exchange risk, although they can be perplexing for newcomers in terms of their characteristics and pricing.

An outright FX forward contract entails two parties agreeing to exchange a predetermined amount of one currency for another on a fixed future date. In contrast to an FX spot contract, which settles within two business days, an FX forward is settled on a previously agreed date that is three or more business days after the agreement. Essentially, FX Forwards are contracts that establish an agreement to exchange a specific amount of currency at a set future date, with the exchange rate fixed at the time of the contract (the “trade date”), while the settlement occurs a few days later. The interval between the trade date and the settlement date is known as the “settlement convention.” There is also an additional settlement convention that takes place after the contract's maturity date, allowing for currency exchange.

The primary distinction between FX Forward transactions and Spot market transactions is that spot transactions involve immediate delivery, whereas FX Forwards stipulate future delivery, resulting in different pricing based on the relevant interest rates. A common misunderstanding is that FX Forwards represent the anticipated future price of a currency pair; however, they actually reflect the relevant interest rates and the duration of the contract without forecasting price movements.

FX Forwards are different from FX Futures in that forward contracts are not standardized; their terms are negotiated on an individual basis. A forward contract is a private agreement traded over the counter (OTC) among banks and brokers, while futures contracts are standardized and traded on organized markets, allowing for resale at market prices until the trading period concludes. Futures contracts are managed through a clearinghouse, which mitigates counterparty credit risk by marking contracts to market daily. Conversely, closing or reversing a forward contract necessitates a second contract, which may involve different counterparties and associated credit risks.

FX Forwards are priced based on the interest rates relevant to the currencies involved. When acquiring an FX Forward, the interest accrual on the purchased currency over the sold currency can generate profit, particularly if the currency exchange at maturity is advantageous. For example, if the spot price for EUR/USD is 1.30 and the 3-month forward price is 1.32, with the ECB rate at 2.5% and the Fed rate at 5%, the forward price would be 1.3082, factoring in accrued interest. If the interest rate differential is negative, the FX Forward will trade at a discount to the spot price to mitigate potential losses.

For instance, a US company needing to pay 100 million yen in 90 days can hedge against FX risk by entering a forward contract at a rate of 97 yen per dollar, safeguarding against potential yen appreciation.

Despite their advantages, FX Forwards come with risks, primarily credit risk, since the transaction does not settle immediately. If the counterparty defaults at maturity, the initial party may incur losses. Additionally, FX Forwards lock in exchange rates, which can introduce interest rate and exchange rate risks. If interest rates fluctuate during the contract, the client cannot capitalize on favorable changes. Similarly, significant shifts in the exchange rate can prevent the client from benefiting from better spot prices. Corporate treasuries must thoroughly assess these risks when utilizing FX Forwards for currency hedging.