Forward Contracts

Forward contracts are a commonly-used method for hedging foreign exchange risk.

Forward contracts

Definitions

The forward market is where you can buy and sell a currency, at a fixed future date for a predetermined rate, i.e. the forward rate of exchange.

How rates are quoted

Forward rates may be given explicitly or quoted as an adjustment (either a 'discount' or 'premium') to the spot rate:

Forward rate = spot rate MINUS a premium

Forward rate = spot rate PLUS a discount

Availability and use

Although other forms of hedging are available, forward cover represents the most frequently employed method of hedging.

However, the existence and depth of forward markets depends on the level of demand for each particular currency.

In exams you need to consider whether the forward market exists and would it extend far enough into the future before you recommend it.

For major trading currency like the $, £, Yen or Euro it can be up to 10 years forward. Normally forward markets extend six months into the future. Forward markets do not exist for the so-called exotic currencies.

Advantages and disadvantages

Forward exchange contracts are used extensively for hedging currency transaction exposures.

Advantages include:

• fixes the future rate, thus eliminating downside risk exposure
• flexibility with regard to the amount to be covered
• relatively straightforward both to comprehend and to organise.

Disadvantages include:

• contractual commitment that must be completed on the due date (option date forward contract can be used if uncertain)
• no opportunity to benefit from favourable movements in exchange rates.
• availability - see above

Other types of forward contracts

Option-dated forwards

A forward contract is a contractual commitment which must be completed on the due date.

This means that if a payment from the overseas customer is late, say, the company receiving the payment and wishing to convert it using its forward exchange contract will have a problem. The existing forward exchange contract must be settled, although the bank will arrange a new forward exchange contract for the new date when the currency cash flow is due.

To help overcome this problem an 'option date' forward exchange contract can be arranged. This is a forward exchange contract that allows the company to settle a forward contract at an agreed fixed rate of exchange, but at any time between two specified dates. If the currency cash flow occurs between these two dates, the forward exchange contract can be settled at the agreed fixed rate.

Synthetic forwards

Some governments, including Russia and India, have banned forward FX trading - usually as a means to reduce exchange rate volatility.

 In such markets the use of non-deliverable forwards (NDFs) has developed. In effect these work like forward contracts where forward contracts are banned.

These are discussed in more detail here.

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Tags:	Forward contracts;option-dated forwards;synthetic forwards