What Is a Forward Exchange Contract?
A forward exchange contract (FEC) is a special type of over the counter (OTC) foreign currency (forex) transaction entered into in order to exchange currencies that are not often traded in forex markets. These may include minor currencies as well as blocked or otherwise inconvertible currencies. A forward exchange contract involving such a blocked currency is known as a non-deliverable forward, or NDF.
Broadly speaking, forward contracts are contractual agreements between two parties to exchange a pair of currencies at a specific time in the future. These transactions typically 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.
- A forward exchange contract is an agreement between two parties to effect a currency transaction, usually involving a currency pair not readily accessible on forex markets.
- Forward exchange contracts are traded OTC with customizable terms and conditions, many times referencing currencies that are illiquid, blocked, or inconvertible.
- Forward exchange contracts are used as a hedge against risk as it protects both parties from unexpected or adverse movements in the currencies' future spot rates when FX trading is otherwise unavailable.
Understanding Forward Exchange Contracts
Forward exchange contracts are not traded on exchanges, and standard amounts of currency are not traded in these agreements. Still, 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. All forward exchange contracts set out the currency pair, notional amount, settlement date, and delivery rate, and also stipulate that the prevailing spot rate on the fixing date be used to conclude the transaction.
The contract's rate of exchange is thus 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 a 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.
The largest forward exchange markets are in the Chinese yuan (CNY), Indian rupee (INR), South Korean won (KRW), New Taiwan dollar (TWD), Brazilian real (BRL), and Russian ruble (RUB). The largest OTC markets take place in London, with active markets also in New York, Singapore, and Hong Kong. Some countries, including South Korea, have limited but restricted onshore forward markets in addition to an active NDF market.
The largest segment of forward exchange contract trading is done against the U.S. dollar (USD). There are also active markets using the euro (EUR), the Japanese yen (JPY), and, to a lesser extent, the British pound (GBP) and the Swiss franc (CHF).
Forward Exchange Calculation and 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