Currency Forward

Definition of 'Currency Forward'

A binding contract in the foreign exchange market that locks in the exchange rate for the purchase or sale of a currency on a future date. A currency forward is essentially a hedging tool that does not involve any upfront payment. The other major benefit of a currency forward is that it can be tailored to a particular amount and delivery period, unlike standardized currency futures. Currency forward settlement can either be on a cash or a delivery basis, provided that the option is mutually acceptable and has been specified beforehand in the contract. Currency forwards are over-the-counter (OTC) instruments, as they do not trade on a centralized exchange. Also known as an “outright forward.”

Investopedia explains 'Currency Forward'

Unlike other hedging mechanisms such as currency futures and options contracts – which require an upfront payment for margin requirements and premium payments, respectively – currency forwards typically do not require an upfront payment when used by large corporations and banks. However, a currency forward has little flexibility and represents a binding obligation, which means that the contract buyer or seller cannot walk away if the “locked in” rate eventually proves to be adverse. Therefore, to compensate for the risk of non-delivery or non-settlement, financial institutions that deal in currency forwards may require a deposit from retail investors or smaller firms with whom they do not have a business relationship.

The mechanism for determining a currency forward rate is straightforward, and depends on interest rate differentials for the currency pair (assuming both currencies are freely traded on the forex market). For example, assume a current spot rate for the Canadian dollar of US$1 = C$1.0500, a one-year interest rate for Canadian dollars of 3%, and one-year interest rate for US dollars of 1.5%.

After one year, based on interest rate parity, US$1 plus interest at 1.5% would be equivalent to C$1.0500 plus interest at 3%.

Or, US$1 (1 + 0.015) = C$1.0500 x (1 + 0.03).

So US$1.0115 = C$1.0815, or US$1 = C$1.0655.

The one-year forward rate in this instance is thus US$ = C$1.0655. Note that because the Canadian dollar has a higher interest rate than the US dollar, it trades at a forward discount to the greenback. As well, the actual spot rate of the Canadian dollar one year from now has no correlation on 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 exchange rate may be in the future.

How does a currency forward work as a hedging mechanism? Assume a Canadian export company is selling US$1 million worth of goods to a U.S. company and expects to receive the export proceeds a year from now. The exporter is concerned that the Canadian dollar may have strengthened from its current rate (of 1.0500) a year from now, which means that it would receive fewer Canadian dollars per US dollar. 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.

If a year from now, the spot rate is US$1 = C$1.0300 – which means that the C$ has appreciated as the exporter had anticipated – by locking in the forward rate, the exporter has benefited to the tune of C$35,500 (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 a year from now is C$1.0800 (i.e. the C$ weakened contrary to the exporter’s expectations), the exporter has a notional loss of C$14,500.

comments powered by Disqus
Hot Definitions
  1. Federal Reserve Note

    The most accurate term used to describe the paper currency (dollar bills) circulated in the United States. These Federal Reserve Notes are printed by the U.S. Treasury at the instruction of the Federal Reserve member banks, who also act as the clearinghouse for local banks that need to increase or reduce their supply of cash on hand.
  2. Benchmark Bond

    A bond that provides a standard against which the performance of other bonds can be measured. Government bonds are almost always used as benchmark bonds. Also referred to as "benchmark issue" or "bellwether issue".
  3. Market Capitalization

    The total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying a company's shares outstanding by the current market price of one share. The investment community uses this figure to determine a company's size, as opposed to sales or total asset figures.
  4. Oil Reserves

    An estimate of the amount of crude oil located in a particular economic region. Oil reserves must have the potential of being extracted under current technological constraints. For example, if oil pools are located at unattainable depths, they would not be considered part of the nation's reserves.
  5. Joint Venture - JV

    A business arrangement in which two or more parties agree to pool their resources for the purpose of accomplishing a specific task. This task can be a new project or any other business activity. In a joint venture (JV), each of the participants is responsible for profits, losses and costs associated with it.
  6. Aggregate Risk

    The exposure of a bank, financial institution, or any type of major investor to foreign exchange contracts - both spot and forward - from a single counterparty or client. Aggregate risk in forex may also be defined as the total exposure of an entity to changes or fluctuations in currency rates.
Trading Center