What is a 'Forward Exchange Contract'

A forward exchange contract is a special type of foreign currency transaction. Forward contracts are agreements between two parties to exchange two designated currencies at a specific time in the future. These contracts always take place on a date after the date that the spot contract settles and are used to protect the buyer from fluctuations in currency prices.

BREAKING DOWN 'Forward Exchange Contract'

Forward contracts are not traded on exchanges, and standard amounts of currency are not traded in these agreements. They cannot be canceled except by the mutual agreement of both parties involved. The parties involved in the contract are generally interested in hedging a foreign exchange position or taking a speculative position. The contract's rate of exchange is fixed and specified for a specific date in the future and allows the parties involved to better budget for future financial projects and known in advance precisely what their income or costs from the transaction will be at the specified future date. The nature of forward exchange contracts protects both parties from unexpected or adverse movements in the currencies' future spot rates.

Generally, forward exchange rates for most currency pairs can be obtained for up to 12 months in the future. There are four pairs of currencies known as the "major pairs." These are the U.S. dollar and euros; the U.S. dollar and Japanese yen; the U.S. dollar and the British pound sterling; and the U.S. dollar and the Swiss franc. For these four pairs, exchange rates for time period of up to 10 years can be obtained. Contract times as short as a few days are also available from many providers. Although a contract can be customized, most entities won't see the full benefit of a forward exchange contract unless setting a minimum contract amount at $30,000.

Calculation Example

The forward exchange rate for a contract can be calculated using four variables:

S = the current spot rate of the currency pair

r(d) = the domestic currency interest rate

r(f) = the foreign currency interest rate

t = time of contract in days

The formula for the forward exchange rate would be:

Forward rate = S x (1 + r(d) x (t / 360)) / (1 + r(f) x (t / 360))

For example, assume that the U.S. dollar and Canadian dollar spot rate is 1.3122. The U.S. three-month rate is 0.75%, and the Canadian three-month rate is 0.25%. The three-month USD/CAD forward exchange contract rate would be calculated as:

Three-month forward rate = 1.3122 x (1 + 0.75% * (90 / 360)) / (1 + 0.25% * (90 / 360)) = 1.3122 x (1.0019 / 1.0006) = 1.3138

RELATED TERMS
  1. Long Dated Forward

    A type of forward contract commonly used in foreign currency ...
  2. Outright Forward

    A forward currency contract with a locked-in exchange rate and ...
  3. Currency Futures

    A transferable futures contract that specifies the price at which ...
  4. Forward Premium

    When dealing with foreign exchange (FX), a situation where the ...
  5. Forward Contract

    A customized contract between two parties to buy or sell an asset ...
  6. Forward Market

    An over-the-counter marketplace that sets the price of a financial ...
Related Articles
  1. Trading

    The Difference Between Forwards and Futures

    Both forward and futures contracts allow investors to buy or sell an asset at a specific time and price.
  2. Trading

    Why Forward Contracts Are The Foundation Of All Derivatives

    This article expands on the complex structure of derivatives by explaining how an investor can assess interest rate parity and implement covered interest arbitrage by using a currency forward ...
  3. Trading

    How To Lock In An Exchange Rate

    Currency risk can be effectively hedged by locking in an exchange rate through the use of currency futures, forwards, options, or exchange-traded funds.
  4. Investing

    Introduction To Currency Futures

    The forex market is not the only way for investors and traders to participate in foreign exchange.
  5. Investing

    What is a Forward Contract?

    A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date.
  6. Investing

    3 Strategies to Mitigate Currency Risk (EUFX)

    Discover the often overlooked risk known as currency risk, and learn three strategies to mitigate or eliminate it in your portfolio.
  7. Trading

    How Currency Forward Contracts Work

    A currency forward contract locks the exchange rate for a currency’s purchase or sale at a future date.
  8. Investing

    4 Reasons Currency Hedging is Important

    Learn how currency hedging can help reduce exchange rate risk for a portfolio of foreign stocks. Consider the cost of hedging and its potential benefits.
  9. Trading

    The Money Market Hedge: How It Works

    Investopedia explains how to hedge foreign exchange risk using the money market, the financial market in which highly liquid and short-term instruments like Treasury bills, bankers’ acceptances ...
  10. Trading

    Using Interest Rate Parity To Trade Forex

    Learn the basics of forward exchange rates and hedging strategies to understand interest rate parity.
RELATED FAQS
  1. What is a forward contract against an export?

    Understand forward exchange contracts in exporting, and learn the purpose of using a forward contract and its advantages ... Read Answer >>
  2. What is the difference between a forward rate and a spot rate?

    Learn about spot and forward contracts, how spot and forward rates are used for spot and forward contracts, and the difference ... Read Answer >>
  3. What is the difference between forward and futures contracts?

    Fundamentally, forward and futures contracts have the same function: both types of contracts allow people to buy or sell ... Read Answer >>
  4. Why is the initial value of a forward contract set to zero?

    Discover why the initial value of a forward contract is set to zero; read about financial mathematics and exchange logic ... Read Answer >>
  5. What kinds of derivatives are types of forward commitments?

    Learn more about what a derivative is, what a forward commitment is and which types of derivative securities have forward ... Read Answer >>
  6. Over what time period should I be looking at the forward rate?

    Read about forward rates and forward prices, how they function, and which rates you should look at based on your own investment ... Read Answer >>
Hot Definitions
  1. Federal Direct Loan Program

    A program that provides low-interest loans to postsecondary students and their parents. The William D. Ford Federal Direct ...
  2. Cash Flow

    The net amount of cash and cash-equivalents moving into and out of a business. Positive cash flow indicates that a company's ...
  3. PLUS Loan

    A low-cost student loan offered to parents of students currently enrolled in post-secondary education. With a PLUS Loan, ...
  4. Graduate Record Examination - GRE

    A standardized exam used to measure one's aptitude for abstract thinking in the areas of analytical writing, mathematics ...
  5. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
  6. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
Trading Center