Definition of Forward Currency (Understanding the Basics) • Benzinga

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Many companies and some wealthy individuals use forward foreign exchange contracts to hedge their future or forward currency exposures in the forex market against adverse movements. Companies exposed to international currency risk typically hedge to help stabilize the domestic value of their foreign currency cash flows or investments.

Futures contracts are traded on the over-the-counter foreign exchange market rather than on an exchange. Other names for a forward currency contract include forward contract and forward currency contract.

If you want to know more about forward exchange contracts, read on.

What is a currency transfer?

In the foreign exchange market, a forward or forward foreign exchange contract involves a binding agreement between two counterparties where one agrees to buy and the other to sell a fixed amount of one currency against another at an agreed rate of exchange or “exchange rate” for delivery on a future delivery date which is generally different from the current spot value date.

Forward foreign exchange contracts are traded in the over-the-counter or over-the-counter foreign exchange market, so their terms can be customized. For example, a counterparty can select a currency pair, notional amount and/or delivery date for the contract that suits their particular needs.

The forward rate for a particular currency pair and value date depends on the prevailing spot rate, the term until delivery, and the interest rate differential between the two currencies involved.

How does a currency transfer work?

Forward exchange contracts are generally settled one day beyond or before the current spot value date. The firm exchange rate of a forward contract must therefore take into account the interest rate differential between the two currencies. This requires knowing the interbank deposit interest rates for each currency relative to the value date of the futures contract.

Unless these deposit interest rates are the same for each currency, the interest rate differential will benefit the counterparty holding the higher interest rate currency during the term of the forward contract.

The counterparty holding the currency with the lower interest rate must compensate the other party to the forward foreign exchange contract by paying the difference between the interest rates over the term of the contract. This difference and the prevailing spot exchange rate are incorporated into a standard formula to derive the forward exchange rate.

The difference in pips between spot and forward exchange rates is known as swap points. These swap points are quoted by forward exchangers to their customers so that the swap points can be easily added to or subtracted from the prevailing spot rate, as appropriate, to calculate the forward rate.

How to calculate a forward rate?

You can determine the firm forward rate of a forward currency contract for a given value date using this formula:

F=S[(1 + ib)/ (1 + ic)]

Where:

F = the forward rate for the currency pair

S = the spot exchange rate for the same pair

Ib = the interbank deposit interest rate in the base currency for the given future value date

ic = the interbank deposit interest rate of the counter currency for the given future value date

However, since the delivery date of a forward foreign exchange contract is often not a full year in the future and interest rates on interbank deposits are usually annualized, you will usually need to convert these annualized rates in fractional interest rates to use the above equation. You can do this conversion using this formula:

si = ia x (Dv/Dy)

Where:
si = fractional annual interest rate

ia = annualized interest rate

Dv = the number of days until the value date of the futures contracts

Dy = the number of days in a year

If you want to determine the swap points that apply on a particular value date for a currency pair, you need to calculate the difference in pips between F (the forward rate that was calculated in the previous equation) and S (the prevailing spot rate for the currency pair). You can use this formula to do that:

Exchange points = F – S

Once you know or are quoted the swap points for a given value date, you can easily calculate the forward rate for delivery on that date based on a spot rate quote. If you are a client of a market maker, remember that you will be buying (selling) the base currency on the bid (offer) side of the spot rate and quoted swap points.

What is the difference between currency futures and currency futures?

The main difference between currency futures and currency futures is that futures are customizable and trade on the OTC forex market while currency futures trade on exchanges such as the Chicago Mercantile Exchange (now part of the CME group) and are standardized in terms of notional amount and value dates.

Example of a Forward in Forex Trading

In practice, futures contracts are usually traded by trading the desired notional amount against the spot value after first obtaining a quote for the swap points from a futures desk for the desired forward value date. The spot position is then deployed to the forward date and the exchange rate is adjusted by the number of swap points indicated.

For example, forward contracts are often used by companies seeking to hedge known currency risk against adverse movements in currency exchange rates. The best types of currency exposures to hedge with a forward currency are known in their amount and date. Futures contracts can be traded in custom amounts and value dates up to 10 years.

As an example of the use of a forward contract, consider the situation of a Canadian company that has entered into a contract in US dollars for goods from a supplier based in the United States. The terms of the contract specify that they will have to pay the supplier US$10 million in three months.

To protect against adverse movements in the USD/CAD exchange rate, the company’s finance department decides to execute a forward transaction to purchase the $10 million with Canadian dollars in advance and deploy them for three months so that they can be delivered in accordance with the contract.

They call a commercial bank they have a good relationship with and ask for an offer on a 3-month $10 million USD/CAD futures contract. The bank’s USD/CAD forex broker quotes the bid side for the USD/CAD spot exchange rate of 1.3200, and the bank’s futures desk quotes the bid side for the three-month swap points of 5 pips or 0.0005 for that amount.

If traded at these quotes, the all-inclusive exchange rate for the three-month futures contract that the Canadian company needs would be (1.3200 + 0.0005) = 1.3205.

Note that since the Canadian dollar is currently paying a higher interest rate than the US dollar, the Canadian dollar is trading at a forward discount to the US dollar. In addition, since the forward rate is simply calculated on the basis of the current deposit interest rate differential relative to the forward value date, it does not incorporate a market view of the future level of the USD/CAD exchange rate on that date.

Forex futures and hedging

The example in the previous section uses a very common forward currency hedging scenario to illustrate how a company can use a forward currency contract to hedge against known future currency exposure.

This is one of the most popular applications of currency futures contracts, and companies engaged in international trade in goods and providing services to foreign companies often use futures contracts to hedge their known exposures to foreign currencies in this way.

In addition, international companies often have offices or subsidiaries abroad which incur significant operating costs. The budgeted amounts of these foreign costs are often covered in advance by head office once they are projected by management.

This prudent hedging practice allows a company’s head office to pre-purchase the expected amount of foreign currency with its home currency to pay in foreign currency for the expected operating expenses that its overseas operations will require. in the future.

Trade Futures With These Top Forex Brokers

Benzinga has helped take the guesswork out of finding a reputable online forex broker by compiling the following table of top forex brokers.

Frequently Asked Questions

Can a currency be sold forward?

1

Can a currency be sold forward?

asked

Jay and Julie Hawk

1

Yes, you can sell one currency in exchange for another currency for a future value date if you can trade in the over-the-counter forex market.

Answer link

replied

Benzinga

Is a forward exchange contract a security?

1

Is a forward exchange contract a security?

asked

Jay and Julie Hawk

1

No, a forward currency contract is more of an over-the-counter contract traded on the foreign exchange market that allows you to lock in an exchange rate for a future delivery date.

Answer link

replied

Benzinga

Are futures contracts risky?

1

Are futures contracts risky?

asked

Jay and Julie Hawk

1

Yes. They are about as risky as a spot transaction in terms of the resulting exposure to exchange rate fluctuations. Futures contracts can also be used to hedge existing currency risks.

Answer link

replied

Benzinga

FOREX.com, registered with the Commodity Futures Trading Commission (CFTC), allows you to trade a wide range of foreign exchange markets as well as spot metals with low prices and fast, quality execution on every trade.

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