Currency Forward Definition
Currency forwards are binding contracts in the foreign exchange (FX) market that allow for buying or selling currency at a predetermined, locked-in exchange rate on a specified future date. Currency forwards, often called “outright forwards,” are traded over the counter (OTC).
Currency forwards are customizable, making them versatile hedging tools in the OTC market.
Traders and companies use currency forwards to effectively manage and mitigate the risks associated with currency fluctuations.
Currency forwards also attract individuals seeking longer-term positions without overnight funding costs. The terms of a currency forward can be tailored to a specific amount and for any maturity or delivery period.
Key Takeaways
- Currency forwards are used by importers, exporters, and international companies to hedge against fluctuations in exchange rates, providing a way to lock in an exchange rate for a specified period.
- Unlike currency futures, which have standardized terms and are traded on exchanges, currency forwards are customizable and traded over the counter (OTC), allowing tailored agreements between parties.
- Pricing for currency forwards is determined by the spot price, the interest rate difference between the currencies involved, and the length of the contract.
- Participants in a currency forward contract are obligated to follow through with the transaction at the locked-in rate, even if the market moves unfavorably, potentially requiring additional margin deposits.
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How Currency Forwards Are Priced and Settled
The contract pricing is determined by the spot price, the interest rate difference between the currencies, and the length of the contract. While not traded on exchanges, currency forwards usually require a small upfront deposit similar to a margin payment. Other hedging mechanisms, such as currency futures and options contracts, also require an upfront cost for margin requirements.
A currency forward is a binding obligation, meaning the contract buyer or seller cannot walk away if the locked-in exchange rate proves adverse. If the market turns against the trader or institution, they might need to deposit more to meet the margin requirement.
Fast Fact
Importers and exporters generally use currency forwards to hedge against fluctuations in exchange rates.
Example of Calculating Currency Forward Rates
Computing a currency forward rate takes into account interest rate differentials for the currency pair. Assume a current spot rate for the U.S. dollar vs Canadian dollar is US$1 = C$1.0500, a one-year interest rate for Canadian dollars of 3%, and a one-year interest rate for U.S. dollars of 1.5%. After one year, based on interest rate parity, US$1 plus interest at 1.5% equals C$1.0500 plus interest at 3%:
- $1 (1 + 0.015) = C$1.0500 × (1 + 0.03)
- US$1.015 = C$1.0815
- US$1 = C$1.0655
- The one-year forward rate is thus US$1 = C$1.0655
The Canadian dollar’s higher interest rate causes it to trade at a forward discount compared to the U.S. dollar. The actual spot rate of the Canadian dollar in one year does not correlate with the one-year forward rate at present. The currency forward rate is merely based on interest rate differentials and does not incorporate investors’ expectations of where the actual future exchange rate may be.
Using Currency Forwards for Hedging Risks
A currency forward is commonly used as a hedging mechanism. Assume a Canadian export company sells US$1 million of goods to a U.S. company and expects to receive the export proceeds in one year. The exporter is concerned that the Canadian dollar may strengthen from its current rate of 1.0500, and it would thus receive fewer Canadian dollars per U.S. dollar in one year.
The Canadian exporter, therefore, enters into a forward contract to sell $1 million a year from now at the forward rate of US$1 = C$1.0655. At the one-year mark, if the spot rate is US$1 = C$1.0300, and the C$ appreciated as the exporter had anticipated, the exporter benefited by C$35,500 by locking in the rate by selling the US$1 million at C$1.0655, rather than at the spot rate of C$1.0300.
On the other hand, if the spot rate in one year is C$1.0800 and the Canadian dollar weakened, the exporter will have a notional loss of C$14,500.
It is common practice for international companies to hedge their FX exposure with currency forwards, as it allows them to ensure that both costs and revenues remain predictable and stable.
What Is the Difference Between Currency Forwards and Currency Futures?
Why Are Currency Forwards Used?
Currency forwards lock in an exchange rate for a certain period to hedge against foreign currency exposure.
Can All Currency Pairs Be Used for Currency Forwards?
Currency forwards are individually negotiated, customizable, and traded over the counter (OTC), meaning contracts can be made with any currency.
The Bottom Line
Currency forwards are over-the-counter (OTC) instruments that allow participants to lock in an exchange rate for a future date, providing stability in financial planning.
Currency forwards offer flexibility and customization, enabling individuals and companies to tailor terms to suit their specific needs and time frames without exchange restrictions.
Interest rate differences, contract length, and the spot price are important in determining currency forward pricing.
Currency forwards are an essential hedging tool for companies involved in international trade, helping them mitigate risks associated with currency fluctuations and keep costs and revenues predictable and stable. An example would be a U.S.-based company that imports its product from Mexico using a forward contract to hedge against fluctuations in the Mexican peso.
One of the risks of entering into a currency forward contract is the potential need for additional margin requirements if market conditions change.
