Forward Contract

A forward contract is a private agreement between two parties to exchange one currency for another, or to buy and sell another asset, on a specified future date at a rate or price fixed when the contract is made. In foreign exchange, where the instrument is often called an outright forward, a forward lets an importer, exporter or investor lock in today the rate at which it will convert currency weeks or months later. The contract is binding on both sides: each party must deliver on the settlement date regardless of where the market rate has moved. That obligation provides certainty, but it also creates risk if the underlying commercial payment is delayed, reduced or never happens.

Forwards are among the oldest derivatives. Unlike a futures contract, a forward is traded over the counter, can be tailored to any amount and date, and is usually not cleared through a central counterparty.

The two parties agree the currency pair, the amount, the settlement date and the forward rate. Nothing usually changes hands at inception, although banks may require collateral or a credit line. On the value date, the parties exchange the agreed amounts. If the customer's need disappears, the forward can be closed out by entering an offsetting contract, and the customer pays or receives the difference between the forward rate and the prevailing rate for that date.

Variants include the window forward, which allows delivery at any time within a period, and the non-deliverable forward (NDF), which is settled in cash, usually in US dollars, for the difference between the contract rate and a published fixing. NDFs are used for currencies whose convertibility is restricted, so offshore parties cannot take delivery of the currency itself.

The forward rate is not a forecast of the future spot rate. It is derived from the spot rate and the interest rate differential between the two currencies, a relationship known as covered interest parity. The currency with the higher interest rate trades at a forward discount, and the one with the lower rate at a premium, so that no riskless profit can be made by borrowing in one currency, converting, investing in the other and locking in the conversion back. The difference between the spot and forward rates is quoted in forward points.

Example

Suppose EUR/USD trades at 1.1000 spot, one-year US dollar interest rates are 5 percent and euro rates are 3 percent. The one-year forward rate is approximately 1.1000 × (1.05 ÷ 1.03), or about 1.1214. A US company that must pay EUR 1,000,000 to a supplier in a year can buy euros forward at 1.1214, fixing its cost at USD 1,121,400. If the euro rises to 1.2000 by then, the company has saved about USD 78,600 compared with buying at spot; if the euro falls to 1.0500, it still pays USD 1,121,400 and forgoes the benefit. In practice, departures from parity, measured by the cross-currency basis, and the bank's own margin also affect the rate.

Forwards are the standard tool for hedging known foreign-currency cash flows, such as invoices payable under supplier payment terms, export receivables, dividend repatriation and loan repayments. Payment firms and remittance companies use forwards to cover rates they have quoted to customers, and corporate treasuries often hedge a percentage of forecast flows on a rolling basis. A forward combined with an opposite spot transaction forms an FX swap. Where a business has foreign costs and revenues in the same currency, a natural hedge can reduce the need for forwards.

• Underlying exposure risk: if a buyer cancels an order or pays late, the hedger still owes delivery under the forward and may have to close it out at a loss. Small businesses sometimes discover this only when the exposure fails to materialize.
• Counterparty credit risk: each side depends on the other to perform; banks manage this with credit limits, collateral and, increasingly, margin requirements that can trigger a margin call when rates move.
• Settlement risk: on the value date, one party may pay its currency without receiving the other, which is why many trades settle through CLS on a payment-versus-payment basis.
• Opportunity cost: a hedger gives up gains from favorable moves, which is why some prefer an options contract, which provides protection for a premium while preserving upside.

Treatment of FX forwards differs by jurisdiction. In the European Union, physically settled FX forwards used for payment purposes can fall outside the definition of a financial instrument, while NDFs and speculative forwards are regulated derivatives. In the United States, deliverable FX forwards were exempted from certain swap rules under the Dodd-Frank Act but remain subject to reporting and business conduct standards. Payment firms offering forwards to clients should check whether doing so requires an investment license in addition to a payments license.