Forex Forward Contracts

Forex forward contracts or “forwards” are useful currency hedging and trading instruments. They allow hedgers to lock in a particular foreign exchange rate on a specific amount of currency at a future date and they permit longer-term currency traders to roll out their strategic positions at one time instead of paying daily rollover spreads.

Using forward contracts as hedges is an essential part of managing foreign exchange risk that helps both companies and fund managers of international portfolios protect their foreign assets against fluctuations in exchange rates when those exposures are known in terms of currency pair, date and size.

Forward Transactions

When executing forward forex contracts, you will buy or sell a certain quantity of one currency against the other. You will do so at an agreed-upon forward exchange rate and future delivery date.

To provide forward rates, market-makers working on the forward desk generally take the prevailing market interest rates for each of the currencies involved at the two commonly-traded maturity dates that surround the specific date you need and then they straight-line interpolate the rates to the date you request. They then use the interpolated rates to calculate the resulting forward swap and then the forward rate you need based on the current prevailing spot rate for the currency pair.

The Existence and Direction of Swap Points

Some traders new to forex question why they need to pay swap points at all, and the reason is that the interest rates for deposits in each of the currencies involved may differ, and this differential creates a cost of carry for the holder of the lower interest rate currency. This cost is simply passed on by the market-maker in quoting the swap points.

Accordingly, if a forex swap market-maker is asked to buy for spot delivery and sell for forward delivery the base currency with the higher interest rate among the currency pair involved, their cost of carrying the transaction to delivery will be positive. Hence, the forex swap they quote will be positive, and the resulting forward rate will be higher than the spot rate.

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Typical Forward Transaction Costs and Liquidity

In terms of the typical transaction costs involved in executing a forward foreign exchange contract, hedgers and traders should first expect to pay the normal spot market-maker’s spread. In addition, they will also need to pay the forward swap spread determined by the forward desk from the spread between prevailing interest rates in the currency pair you are interested in and that correspond to the delivery date you request. This swap spread tends to widen the further out the delivery date is from the transaction date.

A considerable improvement in liquidity is usually observed with the commonly-traded maturities like six-month or one-year forwards, and this will tend to result in tighter market-maker spreads for those maturities. While traders are better able to take advantage of this improved pricing because of their greater flexibility, most hedgers prefer to transact forward foreign exchange contracts for the precise delivery date involved in the terms of the contract they are protecting.

Foreign Exchange Forward Example

For example, perhaps your company is based in Australia, but it enters into a contract to sell U.S. Dollar $1,000,000 worth of goods with a delivery date in three months’ time. If the value of the U.S. Dollar goes down relative to the Australian Dollar at the end of those three months, then your company will receive less Australian Dollars for the sale than had been anticipated and this might result in hardship or even a loss on the transaction.

Entering into a forward contract to sell the anticipated receipt of US$1,000,000 and buy the corresponding amount of Australian Dollars with a three month forward delivery date will suitably protect your company against adverse fluctuations in the AUD/USD exchange rate. The forward rate you will then be quoted will be based on the offer side for the prevailing AUD/USD spot rate and the offer side of the three month AUD/USD swap pricing (since AUD is the base currency in the standard quotation). This forward rate will now set the amount of AUD your company will receive from this contract.