FX Forward Contracts

What is an FX Forward Contract and how is the forward rate determined?

An FX Forward Contract is a customized derivative agreement between two parties to buy or sell a specific amount of currency at a rate fixed today, but with settlement occurring at a specified date in the future (e.g., 90 days). This contract is crucial for hedging currency risk. The forward rate is not a prediction of the future spot rate; rather, it is calculated based on the current spot rate and the interest rate differential between the two currencies involved. The formula accounts for the cost of carrying the currency for the duration of the contract, ensuring a no-arbitrage relationship. For example, if the foreign interest rate is higher than the domestic rate, the forward rate will be at a discount to the spot rate.

When and why are FX Forward Contracts used by businesses?

Forward contracts are primarily used by businesses engaged in international trade to mitigate foreign exchange risk. If a UK exporter expects to receive €500,000 in three months for goods sold, they face the risk that the Euro might weaken against the Pound Sterling before payment arrives. By locking in a forward rate today (e.g., €1.16/£), the exporter guarantees the sterling equivalent of their future euro revenue, eliminating uncertainty. This stability allows businesses to accurately budget, manage profit margins, and protect against adverse currency movements, ensuring financial certainty for known future cash flows.

How does the settlement process of a forward contract work at maturity?

At the maturity date specified in the contract, the two parties execute the currency exchange at the rate agreed upon when the contract was initiated, irrespective of what the prevailing spot market rate is at that time. No money changes hands until maturity (except possibly a margin deposit). Using the previous example, if the UK exporter locked in €1.16/£, and the spot rate on the settlement day is €1.20/£, the exporter still receives the amount calculated using the €1.16/£ rate. Conversely, if the spot rate was €1.10/£, the exporter benefits by receiving the higher pre-agreed rate. The settlement is mandatory and binding for both parties.

What are the risks associated with FX Forward Contracts?

While forward contracts eliminate exchange rate volatility risk, they introduce other risks. The primary risk is counterparty risk, which is the possibility that the other party to the contract defaults before settlement. Since forward contracts are typically Over-the-Counter (OTC) and not traded on exchanges, they lack the clearing house guarantee found in futures contracts. Additionally, there is opportunity cost risk; if the spot rate moves favorably (e.g., the Euro strengthens significantly in the exporter's favor), the exporter is legally bound to the less favorable forward rate, meaning they miss out on potential profit. Finally, liquidity risk exists for highly customized, long-dated contracts, making it difficult to unwind the position before maturity.