What Is a Currency Forward?
In the foreign exchange market, a currency forward is a legally binding agreement that fixes the exchange rate for the purchase or selling of a currency at a future time. A currency forward is simply a hedging strategy that may be customized and does not need an initial margin deposit.
The second key advantage of a currency forward is that, unlike exchange-traded currency futures, its conditions may be customized to a specific amount and for any maturity or delivery date.
Understanding Currency Forwards
When utilized by major firms and banks, currency forwards normally do not demand an upfront payment, in contrast to other hedging techniques like currency futures and options contracts—which each require an upfront payment for margin requirements and premium payments, respectively.
However, a currency forward has minimal wiggle room and is a legally binding commitment, thus the contract buyer or seller cannot back out if the “locked-in” rate ultimately turns out to be unfavorable. Financial institutions that deal in currency forwards may thus request a deposit from ordinary investors or smaller businesses with whom they do not already have a commercial connection to offset the risk of non-delivery or non-settlement.
If the option is mutually accepted and has been defined in advance in the contract, currency forward settlement may be done on either a cash basis or a delivery basis. Since they are not traded on a controlled exchange, currency futures are over-the-counter (OTC) products and are sometimes referred to as “outright forwards.”
In fact, currency futures are a common way for importers and exporters to protect themselves against exchange rate swings.
Typical Currency Forwards
Simple mathematical formulas are used to calculate currency forward rates, which are based on interest rate differences between the two currencies (assuming both currencies are freely traded on the forex market).
Assume, for instance, that the current spot exchange rate for the Canadian dollar is US$1 = C$1.0500, that the interest rate for Canadian dollars over one year is 3%, and that the interest rate for US dollars over one year is 1.5%.
According to interest rate parity, after a year, US$1 plus interest at a rate of 1.5 percent would be comparable to C$1.0500 plus interest at a rate of 3 percent, which means:
- $1 (1 + 0.015) = C$1.0500 x (1 + 0.03)
- US$1.015 = C$1.0815, or US$1 = C$1.0655
This means that the one-year forward rate in this case is US$ = C$1.0655. It should be noted that the Canadian dollar trades at a forward discount to the US dollar since it has a higher interest rate than the latter. Furthermore, there is currently no association between the one-year forward rate and the actual spot rate of the Canadian dollar one year from now.
The currency forward rate does not take into account investors’ estimates of where the real exchange rate may be in the future; instead, it is solely based on interest rate differences.
Currency Forwards and Hedging
How does the hedging process of a currency forward work? Let’s say a Canadian export business sells $1 million worth of products to a U.S. business and anticipates receiving the export revenue in 12 months. In a year, the exporter fears that the Canadian dollar may have risen from its present level (1.0500), which would result in a lower exchange rate between the two currencies. As a result, the Canadian exporter signs a forward contract to sell $1 million at the forward exchange rate of US$1 = C$1.0655 one year from today.
By locking in the forward rate, the exporter has gained 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$1.0300), which would suggest that the C$ has risen as the exporter had expected. However, if the spot rate is C$1.0800 in a year (meaning that the Canadian dollar declined against the exporter’s expectations), the exporter will have suffered a notional loss of C$14,500.
What Distinguishes Currency Futures from Currency Forwards?
Currency futures and forwards have many similarities. The primary distinction is that whereas forwards have configurable terms and are sold over-the-counter, currency futures have standardized terms and are traded on markets like the Chicago Mercantile Exchange (CME) (OTC).
Why Do People Use Currency Forwards?
The use of currency futures allows for the temporary fixation of an exchange rate. This is often used to limit exposure to foreign exchange risk.
Which Currencies Are Acceptable for Writing Currency Forwards?
Currency futures may occur on any number of currency pairings due to their adaptability and OTC trading. Which ones would be chosen would depend on the counterparties to the deal.
