What are FX forwards?

FX forwards are binding agreements between two parties, typically a business and a financial institution, to exchange one currency for another at a predetermined exchange rate on a specific future date. Companies use FX forwards to hedge against fluctuating exchange rates and provide greater financial certainty.

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How do FX forward contracts lock in exchange rates for future transactions?

An FX forward contract, also known as a currency forward, is an agreement between two parties to exchange a specific amount of one currency for another at a set exchange rate on a future date.

Currency forwards are traded over-the-counter (OTC) and are binding contracts, meaning the buyer and seller are obligated to fulfil the agreement regardless of market conditions. Their pricing is based on the current exchange spot price, interest rate differences between the two currencies, and length of time to expiration. The terms of the contract can be customized to specific amounts and for any maturity or delivery period.

Businesses operating in international trade use FX forwards to hedge against exchange rate fluctuations and provide greater financial stability and predictability.

For example, consider a U.S. company planning to sell €2 million worth of goods to a French client, with payment due in 12 months. If the company is worried the euro might weaken against the dollar, it can use an FX forward to lock in today’s exchange rate of $1 = €0.90. If the euro does weaken over the next year, the U.S. company is protected from losing money when converting euros back to dollars.

However, FX forwards are legally binding contracts. This means that if the spot rate moves in the company’s favor (like €1 = $1.10 instead of the agreed forward rate), the company must still honor the contract and forgo any potential gains. Despite that, FX forwards can be valuable for minimizing uncertainty and securing future cash flow.

What role do exchange rates play in forward pricing strategies?

Exchange rates play a key role in forward pricing strategies because they serve as the baseline for calculating forward contract rates. FX forward pricing is based on the spot exchange rate adjusted for the interest rate differential between the two currencies. This ensures that forward contracts reflect the cost of holding one currency versus another over time.

For example, a currency with higher interest rates typically trades at a discount in the forward market, while currencies with lower interest rates trade at a premium. This is because investors would otherwise take advantage of the interest rate difference by borrowing in the lower-yielding currency and investing in the higher-yielding one.

Businesses incorporate exchange rate expectations into their hedging strategies by using FX forwards to lock in future rates. For example, an importer buying goods from a foreign supplier can use a forward contract to secure a fixed exchange rate and stabilize costs, regardless of market fluctuations. Multinational companies also use FX forward contracts to hedge against currency risk when managing overseas revenues and expenses.

Key differences between FX forwards and futures for corporate hedging

Both FX forwards and futures are used to hedge currency risk, but they differ in terms of flexibility, customization, and trading.

FX forwards

FX forwards are customizable OTC contracts negotiated directly between two parties, typically a business and a financial institution. These contracts lock in a specific exchange rate for a future date to help companies manage the uncertainty of currency fluctuations.

The key features of FX forwards include:

• Fully customizable (in terms of amount, settlement date, currency pair)
• Privately negotiated OTC for flexibility
• Higher counterparty risk as no central clearinghouse guarantees the trade.

FX futures

FX futures are standardized financial contracts traded on regulated exchanges like the Chicago Mercantile Exchange (CME). Like forwards, futures contracts obligate the buyer and seller to exchange a specific amount of currency at a predetermined rate on a set future date.

The key features of FX futures include:

• Standardized contract sizes and expiration dates
• Traded on public exchanges for greater price transparency
• Marked-to-market daily, which reduces credit risk through a clearinghouse.

FX forwards vs FX futures

The table below highlights the key differences between currency forwards and futures.

In short, FX forwards are ideal for businesses needing tailored FX hedging solutions,  while FX futures are more suitable for companies seeking a standardized and cost-effective way to manage currency risk.

Risks in FX forwards and mitigation for commercial entities

FX forwards can be useful tools for managing currency risk, however they also carry their own risks that companies must consider. These include:

Loss of potential gains from favorable exchange rate movements

FX forwards fix the exchange rate for a future settlement date. While this can protect a company from adverse movements, it also prevents the business from benefiting if the market moves in its favor. For example, if the spot rate at the settlement date is more favorable than the agreed forward exchange rate, the business misses out on potential gains.

Mismatch between expectations and market reality

FX forwards are based on predictions of how exchange rates will move. If the actual exchange rate behaves differently than expected, the forward contract may turn out to not have been the best choice compared to other currency products or strategies.

Higher risk for longer contracts

The longer the time between entering the forward contract and the delivery date, the greater the exposure to unpredictable market fluctuations (i.e. higher risk). For example, a 12-month forward contract carries significantly more risk compared to a one-month contract.

Case examples: FX forwards in multinational corporate finance

Consider a German company importing electronics from Japan. The company needs to pay JPY 10,000,000 in six months and wants to hedge against currency fluctuations. It enters into a six-month FX forward contract where the forward rate is determined by the interest rate differentials between the euro (EUR) and Japanese yen (JPY).

For this example, we assume:

• EUR/JPY spot rate: 1 EUR = JPY 150.000
• 6-month EUR interest rate: 2% per annum
• 6-month JPY interest rate: 6% per annum
• Time period: 6 months (180 days)

Step 1: Calculate the future value of EUR and JPY

The future value of 1 EUR and JPY 150.000 after 180 days is determined using the respective interest rates:

Future EUR Value = 1.000 x (1 + 0.012 / 2) = 1.0006

Future JPY Value = 150.000 x (1 + 0.006 / 2) = 150.450

Step 2: Determine the forward rate

The forward rate is calculated as:

Forward Rate (EUR/JPY) = 150.450 / 1.0006 = 150.360

Step 3: Convert the future payment

To settle the payment of JPY 10,000,000 in six months using the forward rate, the equivalent EUR amount is:

EUR Payment = 10,000,000 / 150.360 = 66,531.94 EUR.

Since the EUR interest rate (1.2%) is higher than the JPY interest rate (0.6%), the forward rate (150.360) is slightly lower than the spot rate (150.000). This means that the euro is trading at a forward discount relative to the yen. This suggests that fewer euros will be needed to buy the same amount of yen in six months.

However if the JPY interest rate were higher than the EUR interest rate, the forward rate would be higher than the spot rate. This means the euro would trade at a forward premium relative to the yen, reflecting the higher return on JPY deposits. As a result, the forward rate would require more euros to purchase the same amount of yen in six months compared to today’s spot rate.

For the German company, this would mean hedging via a forward contract locks in a higher exchange rate for future payments, which could increase hedging costs compared to waiting and converting at the future spot rate. Whether this is a good decision or not depends on how much exchange rate certainty the company requires versus the cost of hedging.

Why are future dates essential in currency forward agreements?

Future dates are essential in currency forward agreements because they determine when the agreed-upon exchange of currencies will occur. By locking in exchange rates today for transactions scheduled at a specific future date, businesses can manage exchange rate risks and budget more effectively.

How do currency forwards protect against exchange rate volatility?

Currency forwards protect against exchange rate volatility by allowing companies to lock in a fixed exchange rate for a future transaction, shielding them from unexpected market fluctuations and allowing for greater cost predictability.

This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.