What Is a Currency Forward?

Currency forwards are 澳洲幸运5官方开奖结果体彩网:over-the-counter (OTC) instruments known as “澳洲幸运5官方开奖结果体彩网:outright forwards.” It is a binding contract in the foreign exchange (FX) market that locks in the 澳洲幸运5官方开奖结果体彩网:exchange rate for the purchase or sale of a currency on a future date.ไ

A currency forward may appeal to individuals who prefer to take positions over the longer term without incurring overnight funding costs. Its terms can be tailored to a specific amount and for any maturity or delivery period.

Pricing and Settlement

The contract pricing is determined by the spot price, the interest rate difference between the currencies, and the length of the contract. A currency forward is not exchange traded, yet it still commonly requires a small upfront deposit, akin to a margin payment. Other hedging mechanisms such as 澳洲幸运5官方开奖结果体彩网:currency futures and 澳洲幸运5官方开奖结果体彩网:options contracts also require an upfront cost for ꦐmargin requirements.

A currency forward is a binding obligation, meaning the contract buyer or seller cannot walk away if the “locked-in” 澳洲幸运5官方开奖结果体彩网:exchange rate proves adverse. If the market moves negatively against the trader or financial institution, they may be required to make an additional deposit to satisfy the margin requirement.

Currency Forward Example

Computing a currency forward rate takes into account interest rate differentials for the 澳洲幸运5官方开奖结果体彩网: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 US dollars of 1.5%. After one year, based on 澳洲幸运5官方开奖结果体彩网:interest rate parity, US$1 plus inte🃏rest at 1.5% equals C$1.0500 plus interest at 3%:

• $1 (1 + 0.015) = C$1.0500 x (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

Because the Canadian dollar has a higher interest rate than the US dollar, it trades at a 澳洲幸运5官方开奖结果体彩网:forward discount to the 澳洲幸运5官方开奖结果体彩网:greenback. 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 differentiꦿals and does not incorporate investors’ expectations of where the actual future ex𓂃change rate may be.

Hedging

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 expo🌟rter is concerned that the Canadian dollar may strengthen from its current rate of 1.0500 and it would receive fewer Canadian dol💎lars per US dollar in one year.

The Canadian exporter, therefore, enters into a 澳洲幸运5官方开奖结果体彩网:forward contract to sell $1 million a year from now at the forward rate ꧙of 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 dol﷽lar 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 to ensure that both costs♋ and revenues remain predictable and stable.

The Bottom Line

Currency forwards are OTC-traded, privately-negotiated deals used in forex markets to lock in an exchange rate for a currency pair. The contract’s pricing terms depend on the interest rate differential between currenciꦕes and the contract length. They are highly-customizable and are commonly used for hedging by both traders and companies with international business interests.