CFA Level 1

Derivatives - Currency Forward Contracts

Foreign currency forward contracts are used as a foreign currency hedge when an investor has an obligation to either make or take a foreign currency payment at some point in the future. If the date of the foreign currency payment and the last trading date of the foreign currency forwards contract are matched up, the investor has in effect "locked in" the exchange rate payment amount.

By locking into a forward contract to sell a currency, the seller sets a future exchange rate with no upfront cost. For example, a U.S. exporter signs a contract today to sell hardware to a French importer. The terms of the contract require the importer to pay euros in six months' time. The exporter now has a known euro receivable. Over the next six months, the dollar value of the euro receivable will rise or fall depending on fluctuations in the exchange rate. To mitigate his uncertainty about the direction of the exchange rate, the exporter may elect to lock in the rate at which he will sell the euros and buy dollars in six months. To accomplish this, he hedges the euro receivable by locking in a forward.

This arrangement leaves the exporter fully protected should the currency depreciate below the contract level. However, he gives up all benefits if the currency appreciates. In fact, the seller of a forward rate faces unlimited costs should the currency appreciate. This is a major drawback for many companies that consider this to be the true cost of a forward contract hedge. For companies that consider this to be only an opportunity cost, this aspect of a forward is an acceptable "cost". For this reason, forwards are one of the least forgiving hedging instruments because they require the buyer to accurately estimate the future value of the exposure amount.

Like other future and forward contracts, foreign currency futures contracts have standard contract sizes, time periods, settlement procedures and are traded on regulated exchanges throughout the world. Foreign currency forwards contracts may have different contract sizes, time periods and settlement procedures than futures contracts. Foreign currency forwards contracts are considered over-the-counter (OTC) because there is no centralized trading location and transactions are conducted directly between parties via telephone and online trading platforms at thousands of locations worldwide.

Key Points:

  • Developed and grew in the late '70s when governments relaxed their control over their currencies
  • Used mainly by banks and corporations to mange foreign exchange risk
  • Allows the user to "lock in" or set a future exchange rate.
  • Parties can deliver the currency or settle the difference in rates with cash.

Example: Currency Forward Contracts
Corporation A has a foreign sub in Italy that will be sending it 10 million euros in six months. Corp. A will need to swap the euro for the euros it will be receiving from the sub. In other words, Corp. A is long euros and short dollars. It is short dollars because it will need to purchase them in the near future. Corp. A can wait six months and see what happens in the currency markets or enter into a currency forward contract. To accomplish this, Corp. A can short the forward contract, or euro, and go long the dollar.

Corp. A goes to Citigroup and receives a quote of .935 in six months. This allows Corp. A to buy dollars and sell euros. Now Corp. A will be able to turn its 10 million euros into 10 million x .935 = 935,000 dollars in six months.

Six months from now if rates are at .91, Corp. A will be ecstatic because it will have realized a higher exchange rate. If the rate has increased to .95, Corp. A would still receive the .935 it originally contracts to receive from Citigroup, but in this case, Corp. A will not have received the benefit of a more favorable exchange rate.

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