What Is a Forward Exchange Contract?
A forward exchange contract is a special type of over the counter (OTC) foreign currency transaction. Forward contracts are agreements between two parties to exchange two designated currencies at a specific time in the future. Such a contract may be entered into to exchange currencies that are not often traded in forex markets. These may include minor currencies as well as blocked or otherwise inconvertible currencies.
These contracts typically take place on a date after the date that the spot contract settles and are used to protect the buyer from fluctuations in currency prices.
A forward exchange contract is an agreement between two parties to exchange two designated currencies at a specific time in the future.
Forward exchange contracts are traded OTC with customizable terms and conditions, sometimes referencing currencies that are not listed on forex exchanges or are very illiquid.
Forward exchange contracts are used as a hedge against risk as it protects both parties from unexpected or adverse movements in the currencies' future spot rates.
Understanding Forward Exchange Contracts
Forward exchange contracts are not traded on exchanges, and standard amounts of currency are not traded in these agreements. Still, they cannot be canceled except by the mutual agreement of both parties involved. The parties involved in the contract are generally interested in hedging a foreign exchange position or taking a speculative position.
The contract's rate of exchange is fixed and specified for a specific date in the future and allows the parties involved to better budget for future financial projects and known in advance precisely what their income or costs from the transaction will be at the specified future date. The nature of forward exchange contracts protects both parties from unexpected or adverse movements in the currencies' future spot rates.
Generally, forward exchange rates for most currency pairs can be obtained for up to 12 months in the future. There are four pairs of currencies known as the "major pairs." These are the U.S. dollar and euros; the U.S. dollar and Japanese yen; the U.S. dollar and the British pound sterling; and the U.S. dollar and the Swiss franc. For these four pairs, exchange rates for a time period of up to 10 years can be obtained.
Contract times as short as a few days are also available from many providers. Although a contract can be customized, most entities won't see the full benefit of a forward exchange contract unless setting a minimum contract amount at $30,000.
Forward Exchange Calculation and Example
The forward exchange rate for a contract can be calculated using four variables:
S = the current spot rate of the currency pair
r(d) = the domestic currency interest rate
r(f) = the foreign currency interest rate
t = time of contract in days
The formula for the forward exchange rate would be:
Forward rate = S x (1 + r(d) x (t / 360)) / (1 + r(f) x (t / 360))
For example, assume that the U.S. dollar and Canadian dollar spot rate is 1.3122. The U.S. three-month rate is 0.75%, and the Canadian three-month rate is 0.25%. The three-month USD/CAD forward exchange contract rate would be calculated as:
Three-month forward rate = 1.3122 x (1 + 0.75% * (90 / 360)) / (1 + 0.25% * (90 / 360)) = 1.3122 x (1.0019 / 1.0006) = 1.3138