Currency Forward

In this article, We learn about "Currency Forward ".Let's Go!

A Forward contract is a non-standardized contract between two parties who agree to complete a transaction at some time in the future.

Both parties agree today to buy (sell) an asset at a specific date in the future at a specific price.

A buyer of an asset takes a "long" position in a contract; a seller of an asset takes a "short" position.

The price agreed between the buyer and the seller is called the delivery price.

FX forwards are a very useful tool for companies wishing to hedge their foreign exchange risk.

However, for those new to FX forwards, there is often some confusion as to what these contracts are and how they are priced.

What is foreign exchange forward?

A direct foreign exchange forward contract is a contract in which two parties agree to deliver a specified amount of one currency in exchange for another at a fixed date in the future.

The only difference with the foreign exchange spot contract is that the foreign exchange forward contract is settled on any pre-agreed date (i.e. 3 or more working days after the transaction), while the settlement or delivery date of the foreign exchange spot contract is no later than 2 working days after transaction.

Simply put, a foreign exchange forward is a contract that establishes an agreement to exchange a specified amount of currency at a predetermined future date.

As far as how these contracts function; the exchange rate for a transaction is agreed upon when the contract is signed (called the “trade date”, with the settlement date occurring a few days later.

The time elapsed between the transaction date and the settlement date is called "settlement agreement".

There are further settlement agreements after the contract expires, allowing currency exchange.

What is the difference between foreign exchange forward transaction and spot market transaction?

The main difference is that spot market transactions are instant delivery.

Forex forward transactions agree to delivery at a future date and are therefore priced differently than the spot market.

Pricing differences are due to the relative interest rate of the transaction.

A common misconception among people who are exposed to these contracts for the first time is that an FX forward represents the price at which a currency pair is expected to trade in the future.

However, this is not the case.

Foreign exchange forward is only a function of relevant interest rate and contract period, and in no way reflects any expectation on the price trend.

What is the difference between foreign exchange forward and foreign exchange futures?

There is an important distinction between a "forward" transaction and a "futures" contract.

Unlike futures contracts, forward contracts are not standardized. Instead, the terms and conditions of each contract are negotiated individually.

A forward contract is a separate agreement between two parties, traded over-the-counter (OTC) in a network of banks and brokers.

Futures contracts are contracts traded in organized markets with a standard size and settlement date that can be resold at market prices before the contract trade ends.

Think of futures contracts as standardized forward contracts traded on organized exchanges, rather than as negotiated and traded on an over-the-counter basis.

Futures contracts are circulated through the clearing house and priced on a daily basis, thereby significantly reducing the credit risk of the counterparty.

Furthermore, the clearing house guarantees that the contract can be canceled by simply buying the second contract, which reverses the first contract and debits the position.

However, in a forward contract, if the holder wants to liquidate or reverse the position, there must be a second contract, and if the second contract is arranged with a different counterparty than the first contract, Then there are two contracts, and two counterparties, with two different types of counterparty credit risk

How are foreign exchange forwards priced?

has some lovely technical formulas, and for the sake of everyone's sanity, we won't bore you here. Instead, here are the key takeaways about FX forward pricing.

When you buy a foreign exchange forward, the accrued interest on the currency you are buying relative to the currency you are selling can be profitable.

This profit can be increased if the currency exchange on the expiry date of the transaction is favorable.

To prevent essentially "risk-free profits", FX forwards have different prices that essentially take into account the interest rate applicable to the underlying currency transaction.

Example of foreign exchange forward pricing

For example, let’s consider the difference between hypothetical pricing of EUR/USD 1.30 in the spot market and EUR/USD 1.32 in a 3-month forward contract.

If the headline ECB rate is 2.5% and the headline Fed rate is 5%, the forward price will be 1.3082.

This equates to $82 in interest accrued during this period.

Similarly, if the short-term spread is negative (the quote currency has a lower interest rate than the base currency), FX forwards will trade at a discount to the spot price.

This is to mitigate the inherent losses arising from interest rate differences.

Here’s a real-life example about a company.

Suppose an American company purchases a product from a Japanese company and pays 100 million yen within 90 days. The importer owes Japanese yen for future deliveries. Assume that the current price of the yen is 1 USD to 100 yen.

Over the next 90 days, the Yen may appreciate against the U.S. dollar, raising the dollar cost of the product.

The importer can avoid this foreign exchange risk by entering into a 90-day forward contract with the bank at 97 yen to 1 dollar, corresponding to the foreign exchange forward rate.

In addition to the hedging purposes shown in this example, foreign exchange forward contracts can also be used for speculative transactions that take on foreign exchange risk by betting on future exchange rate increases or decreases.

What are the risks of foreign exchange forwards?

Credit Risk

While FX forwards are undoubtedly an extremely useful tool for businesses looking to hedge their FX risks, as with all financial transactions and instruments, they are not without risk.

For FX forward, the main threat is credit risk.

Since transactions are not settled immediately (like spot market transactions), there is a risk of default.

If the counterparty fails to meet its obligations by the due date (default), the initiating party may lose some or all of the transaction value.

Exchange rate and interest rate risk

It’s also worth considering that because FX forwards lock in the rate and calculate it based on the spot value at that time (combined with the relevant interest rate parity and contract duration), the customer essentially loses out on the assurance of more favorable terms.

This essentially describes interest rate risk and exchange rate risk.

For example, if the interest rate involved changes during the contract period, the customer will not be able to benefit from any favorable interest rate change.

Likewise, the client cannot benefit from any favorable movement in the underlying spot price if there is a material change in the exchange rate.

It is important for corporate finance departments to assess these risks when using FX forwards as part of currency hedging.

If you want to learn more foreign exchange trading knowledge, please click: Trading Education.


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