Currency Forward

Table of Contents:

• What are currency forwards?
• What is a forward contract
• How to hedge currency risk with forward contracts example
• FAQ's

 

What are currency forwards?

Foreign exchange (FX) forward is a derivative contract that involves the exchange of two different currencies on a specific future date at a fixed rate.

The fixed rate is agreed at the inception of the contract

 

What is a forward contract?

A forward contract is a bespoke bilateral contracts between two parties to buy or sell a underlying asset (such as currency) at a specified price and at a later date.

Forward contracts are fully flexible in terms of notional amounts and maturities, although one-month or three-month forwards are most commonly used for hedging purposes due to better liquidity and lower transaction costs.

 

How to hedge currency risk with forward contracts example

• A UK business sells £100,00 worth of products to a client based in the United States.
• They will receive payment in two months, however during this time they expect the USD to rise against GBP.
• The business therefore enters into a forward contract to lock in the current exchange rate and settle in two months time.

 

FAQ's

Are FX forwards OTC derivatives?

Yes forward contracts are established bilaterally between two trading counterparties,  are not traded on a centralised exchange and are considered as OTC (Over-the-Counter) instruments.

 

What is the difference between a forward rate and spot exchange rate?

The difference between a forward rate and the spot exchange rate mainly derives from the interest-rate differential between the two currencies based on the tenor of forward date.. It can also be affected by the cross-currency basis.

What are the benefits of currency forwards?

• Mitigates FX risks by locking in an exchange rate for settlement at a future date, eliminating the effects of exchange rate volatility
• Provides certainty in forecasting cashflow