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Home  >  About Forex  >  Derivatives  >  Currency forwards


Currency forwards



A Forward (Cash) Contract is an accord whereupon a seller consents to pay a specific commodity in cash to a buyer at some point in the future. Forward contracts are different from futures contracts in that they are not standardized and are negotiated privately.

People in the market often wish to exchange currencies at an unspecified time in the future, however it is beneficial to know the current rate of exchange. Forward foreign exchange contracts are commonly used by importers, exporters as well as investors who attempt to lock in exchange rates in advance so that they can be used at a future time thus hedging their foreign currency cash flows.

For example, suppose an Australian company had signed a contract to purchase something for the price of GBP 1 million to be paid in 3 months time but was worried that within the 3 months, the GBP would rise against the Australian dollar. The company could then agree to buy the USD today to be delivered in 3 months time. This means that the company could negotiate a specific rate at which it could later, at some point in the future, buy GBP setting the amount of GBP to be bought, the date of transaction etc. thus ensuring the purchase price of the Australian Dollar now.

Two separate components are the keys to determining the price in forward transactions. They are the spot price and the forward rate adjustment.

The spot rate is whatever the current market rate is as dictated by the laws of supply and demand. The forward rate adjustment is more complex because it must take into account all applicable interest rates of any currencies involved in the transaction.

Both buying and selling Forward Exchange Contracts, may be either fixed or optional term contracts.

Fixed Term Contracts

Fixed Term Contracts allow the customer to specify the date when the delivery of the overseas currency will occur. Earlier delivery is usually an option, however a marginal adjustment to the Forward Contract Rate may be required.

Optional Term Contracts

Optional Term Contracts allow the customer to enter an agreement for a specific period, where the customer declares a certain period within which they would like the delivery to be made (this normally occurs for periods shorter than one month) eg. a customer may enter a contract for a six month period while having the option of receiving a delivery anytime during the final week.

In both cases there is a contract that effects delivery for both parties: the customer and the bank. An optional delivery contract does not exempt the customer from his obligation to deliver the Forward Exchange Contract. The optional delivery contract exclusively effects the period which the delivery will occur, making it optional.

Forward rates are applicable for transactions in which settlement is expected to occur two or more business days following the transaction date. Forward Contract rates are made up of the Spot rate for the currency being traded which is slightly adjusted due to the relative Forward Margin.

Forward Margins are a reflection of the discrepancy between the interest rates between the two different currencies, and can not be used to forecast the spot rate of a given currency at a later date.

The Forward rate may be stated 3 different ways when related to the spot rate; at parity (par), Premium (more expensive) or at a Discount (cheaper). Thus discounts are added to the spot rate whereas premiums are deducted from the spot rate.

Forward Rates where a 'Premium' exists are favorable to exporters but put importers at a disadvantage when compared to the spot rate on which they are based. Alternatively, Forward rates where a 'Discount' exists put importers at an advantage and are less favorable to exporters when compared to the original relative spot rates.

There is some general rules in helping to determine whether a specific currency will be quoted at a premium or a discount. They are as follows:

1) The currency which has the higher interest rate will be at a discount on a forward basis when compared with the currency with the lower interest rate.

2) Alternatively, the currency with the lower interest rate will be at a premium on a forward basis when compared with the currency with the high interest rate.

3) The larger the discrepancy of interest between the two currencies becomes, the greater the gap between the premium or discount margin will become (i.e. both currencies move farther from parity). Similarly the smaller the discrepancy of interest becomes, the more the gap between the premium and the discount will decrease (ie both currencies move towards parity).

It is worth noting differences and similarities between forward contracts and futures

Similarities:

1. Both forward contacts and futures are derivative securities for future delivery and receipt. Agree on P and Q today for future settlement or delivery in 1 week to 10 years.

2. Both forward contacts and futures are used to hedge currency risk, commodity price risk or interest rate risk.

3. In principal both forward contacts and futures are very similar, both being used to manage risk.

Differences:

1. Forward contracts, unlike futures, are private and custom made contracts between a bank and its clients (MNCs, exporters, importers, etc.) according to the specific needs of the client. No secondary market for forward contracts exists since it is a private contractual agreement, similar to most bank loans.

2. Futures contracts are continually and daily settlement whereas forward contracts are settled at expiration,

3. Most (approximately 90%) of forward contracts are settled with delivery or receipt of the asset. Where as almost all futures contracts (99%) are settled using cash, NOT the delivery of the commodity/asset.

4. Futures markets generally have daily price limits.

Forward Exchange Contracts are bilateral contracts between two different parties. Therefore the onus or responsibility is on each party to assess both the credit standing and capacity of the other party, before entering into a transaction with them.

The deals are extremely flexible with regards to the size of the transaction, the maturity date and the currency involved.

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