What Is a Currency Forward?

A currency forward is a binding contract in the foreign exchange market that locks in the exchange rate for purchasing or selling a coin on a future date. A money forward is essentially a customizable hedging tool that does not involve an upfront margin payment. The other significant benefit of a currency forward is that its terms are not standardized and can be tailored to a particular amount and for any maturity or delivery period, unlike exchange-traded currency futures.

Forward contracts are one of the main methods used to hedge against exchange rate volatility, as they avoid the impact of currency fluctuation over the period covered by the warranty.

Currency forwards is a practical hedging resource and allows buyers to indicate the exact amount to be exchanged and the date on which to settle in the forward contract.

While a currency forward protects the buyer against any adverse movements in the exchange rate, it also means that they will not receive the more favorable rate if the exchange rate moves in their favor.

Currency forwards are traded over-the-counter (they are not traded on a central exchange).

An Example of a Currency Forward

The mechanism for computing a forward currency rate is straightforward and depends on interest rate differentials for the currency pair (assuming both currencies are freely traded on the forex market).

For example, assume 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 a one-year interest rate for US dollars of 1.5 percent.

After one year, based on 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 instance is thus US$ = C$1.0655. The Canadian dollar has a higher interest rate than the US dollar; it trades at a forward discount to the greenback. The actual spot rate of the Canadian dollar one year from now does not correlate with the one-year forward rate at present.

The forward currency rate is merely based on interest rate differentials and does not incorporate investors’ expectations of the actual exchange rate in the future.

Currency Forwards and Hedging

How does a currency forward work as a hedging mechanism? Assume a Canadian export company is selling US$1 million worth of goods to a U.S. company and expects to receive the export proceeds a year from now. The exporter is concerned that the Canadian dollar may have strengthened from its current rate (of 1.0500) a year from now, which means that it would receive fewer Canadian dollars per US dollar. The Canadian exporter, therefore, enters into a forward contract to sell $1 million a year from now at the forward rate of US$1 = C$1.0655.

If a year from now, the spot rate is US$1 = C$1.0300—which means that the C$ has appreciated as the exporter had anticipated – by locking in the forward momentum, 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). On the other hand, if the spot rate a year from now is C$1.0800 (i.e., the Canadian dollar weakened contrary to the exporter’s expectations), the exporter has a notional loss of C$14,500.

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