What Is A Currency Forward?
A Currency Forward is a forward contract where parties involved are obligated to exchange defined amounts of a currency or currencies at a certain exchange rate on or before a mutually agreed upon future date. Businesses and investors often use it to control currency-related risks and hedge against changes in exchange rates.
In this arrangement, the parties to the contract decide which particular currencies will be exchanged, how much will be exchanged, when the transaction will take place in the future, and what will be the exchange rate. In this way, they secure a fixed exchange rate, ensuring stability and safeguarding their financial interests from possible losses brought on by fluctuations in currency values.
Table of contents
- Currency forwards are financial contracts used to hedge against currency exchange rate risks. They offer certainty by allowing parties to lock in a predetermined exchange rate for future currency transactions.
- They can be customized to meet specific needs, providing flexibility and tailored risk management.
- They bring several advantages such as hedging against currency risk and providing price certainty. Some disadvantages include counterparty risk and unfavorable currency movements resulting in losses.
- Currency futures are standardized contracts traded on exchanges, offering more liquidity and transparency. Hence, currency forward contracts differ from currency futures.
Currency Forward Explained
A currency forward contract is a type of foreign exchange arrangement that lets people or companies fix the exchange rate for transactions they will make in the future. This helps shield foreign money transfers—often for up to two years—from the detrimental effects of possible variations or fluctuations in currency rates.
A forward rate contract makes it possible to create a precise budget by fixing the amount receivable in the future today. Therefore, it is advantageous for large purchases such as foreign property purchases. It benefits other contracts like property maintenance costs, savings transfers, and any periodic or phased payments released over time. It can also help plan personal events like weddings (when planned in a foreign country).
Businesses can plan and specify the required currency amount and settlement date for forward contracts at the current exchange rate plus currency forward points, usually up to two years in the future. These points represent the premium or charge paid to sellers to lock a specific amount at a fixed exchange rate (or today’s exchange rate) for receipt in the future. Using this, firms can eliminate uncertainty arising from currency translation, safeguarding profit margins in volatile markets.
A small deposit is paid at the booking stage. When the forward is due for settlement, the deposit paid at the booking stage is deducted from the balance payable on the forward contract. These contracts help entities use money well and allocate it for other purposes, such as lowering the stress associated with budgeting and planning. This is because the money is not due for payment until the date of transfer arrives.
Let us look at some examples to understand the concept better.
Consider Laura is a furniture business owner in the United States who imports goods from London. She expects to make a payment of 1 million Euros to her London supplier in six months. Laura chooses to sign up for a currency forward contract with a bank because she is concerned about future exchange rates.
She agrees to pay the amount in US dollars, independent of future fluctuations in the exchange rate, as long as they agree on an exchange rate now through this arrangement. In this way, she is shielded from possible losses in case the value of the Euro suddenly appreciates.
Consider Party A is in the US, and Party B is in Europe. They enter into a forward contract of 365 days. A is required to pay B for raw materials purchased from B. The annualized interest rate on the price currency is 7%, but the annualized effective interest rate is 7.10% due to compounding.
The annualized interest rate on the base currency (USD) is 5%, but the effective interest rate is 5.07% due to compounding. The spot price of the price currency (EUR) is 20, and the forward price is 20.3860. Hence, 20.3860 is the premium payable today based on the interest rate parity anticipated after one year.
The term effective interest rate refers to the interest rate arrived at in such future transactions due to the compounding effect generated by interest being earned on the interest. This increases the effective interest rate, and Party A would have to pay a higher amount in the future if no forward contract existed.
Advantages And Disadvantages
This section discusses the advantages and disadvantages of such forward contracts.
- Protection against currency risk: These contracts help businesses reduce potential losses prompted by changes in exchange rates, making international transactions more stable.
- Tailored to specific needs: These contracts can be customized to fit the specific requirements of businesses. Parties to the contract fix the transaction amount, currencies (one or more), and contract duration (also called the delivery date).
- Certainty in transactions: By locking in an exchange rate in advance, these instruments provide businesses with assurance that the future costs or revenues of their international transactions will remain fixed. This improves the budgeting function in companies.
- Cash flow management: They enable businesses to effectively manage their cash flows without worrying about fluctuations in foreign exchange rates. This enhances the financial management function in companies.
- Missed opportunity for gains: If exchange rates move favorably (in a direction that benefits a party’s position), businesses lose the chance to enjoy those gains because they have locked a rate while entering into the contract.
- Risk of counterparty failure: The risk of the other party not fulfilling their financial obligations exists in these transactions, too, like other deals that carry counterparty risks. If this happens, a business will likely incur financial losses. Performing due diligence before entering into a contract is important.
- Lack of flexibility: Once such a contract is established, it is generally binding, limiting the ability to make changes if circumstances change unexpectedly.
- Initial deposit requirement: Typically, a deposit is required when parties enter into a contract (at the beginning of the transaction). The deposit amount remains inaccessible for the duration of the contract.
- High risk: Forward contracts can be risky if the exchange rate moves unfavorably in the future, potentially resulting in financial losses. Fulfilling a forward exchange rate contract is a contractual obligation.
- Premium payment: The forward rate quoted is often higher than the spot rate.
Currency Forward vs Currency Future
The differences between currency forwards and currency futures are listed below.
|A currency forward contract is a type of foreign exchange arrangement that lets entities or companies fix the exchange rate for transactions they will execute in the future.
|Currency futures are contracts or trading instruments to buy or sell a specific amount of a currency at a set price on a future date.
|It is a customized agreement between two parties where they exchange currencies at a fixed rate on a specific future date. It is traded Over-the-Counter (OTC), offering flexibility in terms of duration and settlement while executing the said contract.
|A currency future is a standardized contract traded on a regulated exchange. It specifies the amount and date of the currency exchange and offers more liquidity, transparency, and standardization compared to currency forwards.
|It involves negotiations between the parties, and the terms are privately agreed upon. However, such contracts carry default risk as the other party is responsible for the payment.
|They are standardized contracts traded on stock exchanges. Futures contracts are settled daily and have fixed maturity dates and uniform terms. While they carry relatively lower risk since payment is guaranteed on the agreed-upon date, these contracts are not entirely risk-free.
Frequently Asked Questions (FAQs)
To calculate the currency forward rate, one needs the spot exchange rate, interest rates in both currencies, and the time to maturity. It is calculated using the formula: Forward Rate = Spot Rate × (1 + Interest Rate in Foreign Currency) / (1 + Interest Rate in Domestic Currency in the trade).
Currency forward rates are read as the spot exchange rate followed by the number of points. For example, if the spot rate is 2.10 and the forward points are 0, the rate would also be 2.10. Positive or negative forward points indicate a premium or discount on the spot rate.
Currency forward premiums are priced based on the interest rate differentials between the two currencies in question, as well as market expectations of future exchange rate movements. The supply and demand levels in the market also influence the pricing or currency forward premium.
Cross-currency forward points are the base points and are added to or subtracted from the spot rate.
This article has been a guide to what is a Currency Forward. We explain it with its examples, comparison with currency futures, advantages, and disadvantages. You may also find some useful articles here –