Currency Forward

What Is A Currency Forward?

A currency forward is an agreement between a buyer and a seller in the foreign exchange market to lock in a fixed purchase price of a currency at a specified date. 

This fixed currency exchange rate is set at the date the buyer and seller agree to plan for their future inquiries, helping manage your exposure to any potential currency rate fluctuations and protecting you from any setbacks regarding unwanted movements in the market. 

This means you can plan with your business and have a clear budget with no risks of upward or downward exchange-rate movements.

It is a type of futures contract. However, unlike the currency futures, they are tailor-made to any specified amount, maturity, and delivery date; hence, they are not standardized.

Currency forward contracts are also made privately between the two parties to which specific demands must be met by both parties and not be traded on any exchange.   

They also do not require any upfront payments, unlike the futures contracts used by large corporations and banks. 

It is typically a customized hedging tool in which the currency exchange rates are determined by the interest rate of the prevailing two home countries associated with the contract.

Understanding currency forwards

They are used to help fight against risks of exchange rate movements. The contract between the two parties is set to which the conditions should be met. 

These conditions include an agreed-upon exchange rate, the specified amount to exchange, and a time frame of up to 12 months. 

Nonetheless, a currency exchange rate contract is helpful for major purchases such as:

• Importers purchasing supplies from a foreign exporter to which the countries involved have different currencies
• A transfer of savings from one’s country to a foreign country
• Overseas property purchase 
• Overseas property maintenance
• An individual with a financial institution paying for a foreign vacation or education in the future

Forward contracts are often valued at $1 million or more as they are mostly done between a corporation and a financial institution and are not generally used by consumers or small firms.

But how do Multinational corporations use forward contracts?

It could be done in multiple ways:

• Hedge their imports by locking in the rate at which they can obtain the currency
• The bid/Ask Spread is more comprehensive for less liquid currencies.
• May negotiate an offsetting trade if an MNC enters into a forward sale and a forward purchase with the same bank. 
• Non-deliverable forward contracts (NDF) can be used for emerging market currencies where no currency delivery occurs at settlement. Instead, one party makes a payment to the other party.

The formula for calculating currency forward rate

When MNCs anticipate a future need for or future receipt of a foreign currency, they can set up forward contracts to lock in the exchange rate.

The % by which the forward rate (F ) exceeds the spot rate (S ) at a given point in time is called the forward premium (p ).

F = S(1 + p).

Where:

F is the forward rate

S is the spot rate

P is the forward premium or the percentage by which the forward rate exceeds the spot rate

To break it down even more:

F = S x (1 + domestic interest rate)/(1 + foreign interest rate)

F exhibits a discount when p < 0.

• Arbitrage – Arbitrage would be possible if the forward rate were the same as the spot rate.
• Movements in the Forward Rate over Time – The forward premium is influenced by the interest rate differential between the two countries and can change over time.

Offsetting a Forward Contract – An MNC can offset a forward contract by negotiating with the original counterparty bank. 

To calculate the currency forward rate, you need to look at the interest rates of the two countries involved in the contract. Let’s assume:

• The spot rate for the British pound of 1US$ = 1.5£
• The Interest rate for British pounds is 4%
• The Interest rate for US dollars is 2%

After one year, based on interest rate parity:

$1(1 + 0.02) = £1.5(1 + 0.04)

$1.02 = £1.56 or $1 = £1.53

F = £1.53

Advantages and Disadvantages of currency forward

Using a currency forward contract might NOT always work in your favor. This is because you must always factor in the external factors that could affect the exchange rate movements and then act upon them.

Trade wars and volatile domestic politics, to name a few, can affect the currencies and cause fluctuations. Hence, you can align your decision based on the pros and cons of the contract:

The advantages are:

A currency forward contract would limit any downside exposure if the market were to go against your favor after locking in the currency exchange rate. It also gives flexibility with regard to the amount to be covered.

This allows you to plan and budget more effectively without worrying about any downside risk knowing how much currency you will buy or sell.

If the market goes down, this will protect you from any losses. It is also straightforward to comprehend and organize with a potential party.

The disadvantages are:

Once locked into that fixed currency exchange rate for the foreseeable future, there is still a chance you might not prosper from this move. Although the forward contract removes any risk of losses, it eliminates the possibility of profits. 

If the market moves in your favor after having locked in the exchange rate agreed upon with a forward contract, you will not benefit from the new and better rate.

Currency Forward vs. Currency Futures

It could sometimes be confusing to differentiate between a currency forward and a currency future from knowing that one is a type of another. 

Although they are very similar, some key factors help know the difference between them. These factors include:

Differences

Basis	Currency Forward	Currency Future
1. Size in Contract	It is not standardized and can be tailored to individual needs.	It is standardized
2. Delivery Date	It is not standardized and can be tailored to individual needs.	It is standardized
3. Participants	Banks, brokers, and multinational companies. It is also done privately between the two parties.	Banks, brokers, and multinational companies. It can be done publicly.
4. Marketplace	Telecommunications network	Central exchange floor with worldwide communication.
5. Transaction costs	It is set by the ‘spread’ between a bank’s buy and sell prices.	It is negotiated with the use of brokerage fees.
6. Security Deposit	None as such, but compensating bank balances or lines of credit are required.	A small security deposit is required.
7. Liquidation	Most settled by actual delivery. Some offset at a cost.	Most by offset, very few by delivery.

Researched and authored by Jad Shamseddine | LinkedIn

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