A forward contract is a non-standardized contract between two parties, who enter into an agreement to complete a transaction sometime in the future.
The two parties agree today to buy (sell) an asset at a specific date in the future at a specific price.
The buyer of the asset assumes the “long” position of the contract; the seller of the asset assumes the “short” position.
The price that the buyer and the seller agree upon is called the delivery price.
FX Forwards can be an extremely useful tool for businesses looking to hedge their FX exposure.
However, there is often some confusion, for those encountering FX forwards for the first time, as to what these contracts are and how they are prices.
What is FX Forwards?
An outright FX forward contract is a contract where two parties agree to deliver, at a fixed future date, a specified amount of one currency in exchange for another.
The only difference from an FX spot contract is that an FX forward is settled on any pre-agreed date, which is 3 or more business days after the deal, while the FX spot is settled or delivered on a date no later than 2 business days after the deal.
Put simply, FX Forwards are contracts that establish an agreement to exchange a specified amount of currency at a predetermined future date.
In terms of the functionality of these contracts; the exchange rate for the transaction is agreed at the time the contract is entered (known as the “trade date” with the settlement date taking place a few days later.
The time which elapses between the trade date and settlement date is referred to as the “settlement convention”.
There is also a further settlement convention which elapses after the maturity date of the contract, allowing for the exchange of currencies to take place.
How does an FX Forward transaction differ from a Spot market transaction?
The main difference is that the spot market transaction operates with immediate delivery.
An FX Forward transaction agrees on delivery at a future date and as such carries different pricing to the spot market.
The difference in pricing is due to the relevant interest rate on the transaction.
There is a common misconception among those first encountering these contracts that FX Forwards denotes the price at which a currency pair is expected to be trading in the future.
However, this is not the case.
FX Forwards are merely a function of the relevant interest rates and the duration of the contract and in no way reflect any expectations of where the price is headed.
How does an FX Forward differ from FX Futures?
There is an important distinction between “forward” transactions and “futures” contracts.
Unlike futures contracts, forward contracts are not standardized. Instead, the terms and conditions of each contract are negotiated separately.
A forward contract is an individual agreement between two parties and is traded over the counter (OTC) in a network of banks and brokers.
A futures contract is a contract traded on an organized market of a standard size and settlement date, which is resalable at the market price up to the close of trading in the contract.
Think of a futures contract as a standardized forward contract traded on organized exchanges rather than negotiated and traded on an OTC basis.
Futures contracts are channeled through a clearinghouse and marked to market on a daily basis, by which counterparty credit risk is reduced significantly.
Also, the clearinghouse guarantees that a contract can be canceled simply by buying a second contract that reverses the first contract and netting out the position.
In a forward contract, however, if a holder wants to close out or reverse a position, there has to be a second contract, and if the second contract is arranged with a different counterparty from the first, there are two contracts and two counterparties, with two separate types of counterparty credit risk
How are FX Forwards Priced?
There are some lovely technical formulas which we will not bore you within this article, in the interest of everyone’s sanity. Instead, here are the key takeaways regarding FX Forwards pricing.
When you buy an FX Forward, the accrual of interest on the currency purchased, over the currency sold, can lead to profit.
This profit can then be increased if the exchange of currency at the maturity date of the transaction is advantageous.
To protect against what would essentially be “risk-free profit”, FX Forwards carry a different price which essentially considers the interest rates applicable to the currency deal in question.
FX Forward Pricing Example
For example, let’s consider the difference in hypothetical pricing of a EUR/USD 1.30 in the spot market and EUR/USD 1.32 for a 3-month forward contract.
If the ECB headline rate was 2.5% and the Fed’s headline rate was 5%, then the forward price would be 1.3082.
This accounts for the 82 USD which would be accrued in interest over the period.
Similarly, if the short-term interest rate differential is negative (the interest rate of the quote currency is lower than the base currency) then the FX Forward will trade at a discount to the spot price.
This is to mitigate against the intrinsic loss which will be incurred due to the interest rate differential.
Here’s a real-world example regarding a corporation.
Suppose a US company purchases a product from a Japanese company with a payment of 100 million yen due in 90 days. This importer owes yen for future delivery. The current price of the yen is assumed to be 100 yen per dollar.
Over the next 90 days, however, the yen might rise against the US dollar, raising the US dollar cost of the product.
This importer can avoid this FX risk by entering into a 90-day forward contract with a bank at the price of, say, 97 yen per dollar, which corresponds to the FX forward rate.
In addition to the hedging purpose as shown in this example, FX forward contracts can also be used for speculative trades that take on FX risk by betting on a rise or fall of future FX rates.
What Are the Risks With FX Forwards?
While FX Forwards are certainly an extremely useful tool for businesses looking to hedge their FX exposure, they are not without risk, as with all transactions and instruments in financial.
With FX Forwards, the main threat is credit risk.
As the transaction does not undergo immediate settlement (as with spot market transactions), there is the risk of default.
If the counterparty to the transaction is not able to fulfill their obligation (default) at the maturity date, the initial party might lose part or all of the value of their transaction.
Exchange Rate & Interest Rate Risk
It is also worth considering that as FX Forwards lock in an exchange rate and are calculated off the spot value of the time ( in conjunction with the relevant interest rate parity and the duration of the contract) the client essentially loses the ability to secure more advantageous terms.
This essentially describes interest rate risk and exchange rate risk.
For example, if the interest rates involved are altered during the course of the contract, the client is unable to benefit from any advantageous shift in rates.
Similarly, if the exchange rate shifts materially, again, the client is unable to benefit from any advantageous moves in the underlying spot price.
It is important for corporate treasuries to assess these risks when it comes to employing FX Forwards as part of their currency hedging.