Forward Exchange Contract

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. Outright Forward

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

    A transferable futures contract that specifies the price at which ...
  3. Forward Contract

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

    An over-the-counter marketplace that sets the price of a financial ...
  5. Currency Forward

    A binding contract in the foreign exchange market that locks ...
  6. Delivery Date

    1. The final date by which the underlying commodity for a futures ...
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. ETFs & Mutual Funds

    Introduction To Currency Futures

    The forex market is not the only way for investors and traders to participate in foreign exchange.
  5. ETFs & Mutual Funds

    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.
  6. Trading

    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.
  7. Trading

    Using Interest Rate Parity To Trade Forex

    Learn the basics of forward exchange rates and hedging strategies to understand interest rate parity.
  8. Markets

    How to Trade Futures Contracts

    Futures is short for Futures Contracts, which are contracts between a buyer and seller of an asset who agree to exchange goods and money at a future date, but at a price and quantity determined ...
  9. Investing

    Options on Futures

    Options on futures contracts offer another way for day traders to use options. These are traded on the same exchange as the underlying futures contract. Traders should take care to understand ...
  10. Trading

    An Introduction To Trading Forex Futures

    We explain what forex futures are, where they are traded, and the tools you need to successfully trade these derivatives.
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. 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 >>
  5. How is a share premium account taxed?

    Understand the difference between a spot rate and forward rate. Learn why someone would enter into a contract with a spot ... Read Answer >>
  6. How do I convert a spot rate to a forward rate?

    Learn how to convert spot rates to forward rates for financial transactions agreed to today but not to be executed until ... Read Answer >>
Hot Definitions
  1. Glass-Steagall Act

    An act the U.S. Congress passed in 1933 as the Banking Act, which prohibited commercial banks from participating in the investment ...
  2. Quantitative Trading

    Trading strategies based on quantitative analysis which rely on mathematical computations and number crunching to identify ...
  3. Bond Ladder

    A portfolio of fixed-income securities in which each security has a significantly different maturity date. The purpose of ...
  4. Duration

    A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. ...
  5. Dove

    An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that ...
  6. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
Trading Center