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A currency forward is a customizable derivative product and a common hedging tool that is used in the forex market.
Currency forwards are over-the-counter (OTC) instruments known as “outright forwards.” It is a binding contract in the foreign exchange (FX) market that locks in the exchange rate for the purchase or sale of a currency on a future date.
A currency forward may appeal to individuals who prefer to take positions over the longer term without incurring overnight funding costs. Its terms can be tailored to a specific amount and for any maturity or delivery period.
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The contract pricing is determined by the spot price, the interest rate difference between the currencies, and the length of the contract. A currency forward is not exchange traded, yet it still commonly requires a small upfront deposit, akin to a margin payment. Other hedging mechanisms such as currency futures and options contracts also require an upfront cost for margin requirements.
A currency forward is a binding obligation, meaning the contract buyer or seller cannot walk away if the “locked-in” exchange rate proves adverse. If the market moves negatively against the trader or financial institution, they may be required to make an additional deposit to satisfy the margin requirement.
Importers and exporters generally use currency forwards to hedge against fluctuations in exchange rates.
Computing a currency forward rate takes into account interest rate differentials for the currency pair. Assume a current spot rate for the U.S. dollar vs Canadian dollar is US$1 = C$1.0500. A one-year interest rate for Canadian dollars of 3%, and a one-year interest rate for US dollars of 1.5%. After one year, based on interest rate parity, US$1 plus interest at 1.5% equals C$1.0500 plus interest at 3%:
Because the Canadian dollar has a higher interest rate than the US dollar, it trades at a forward discount to the greenback. The actual spot rate of the Canadian dollar in one year does not correlate with the one-year forward rate at present. The currency forward rate is merely based on interest rate differentials and does not incorporate investors’ expectations of where the actual future exchange rate may be.
A currency forward is commonly used as a hedging mechanism. Assume a Canadian export company sells US$1 million of goods to a U.S. company and expects to receive the export proceeds in one year. The exporter is concerned that the Canadian dollar may strengthen from its current rate of 1.0500 and it would receive fewer Canadian dollars per US dollar in one year.
The Canadian exporter, therefore, enters into a forward contract to sell $1 million a year from now at the forward rate of US$1 = C$1.0655. At the one-year mark, if the spot rate is US$1 = C$1.0300, and the C$ appreciated as the exporter had anticipated the exporter benefited by C$35,500 by locking in the rate by selling the US$1 million at C$1.0655, rather than at the spot rate of C$1.0300.
On the other hand, if the spot rate in one year is C$1.0800 and the Canadian dollar weakened, the exporter will have a notional loss of C$14,500.
It is common practice for international companies to hedge their FX exposure with currency forwards, as it allows to ensure that both costs and revenues remain predictable and stable.
Currency futures have standardized terms and are traded on exchanges such as the Chicago Mercantile Exchange (CME). Currency forwards have customizable terms and trade over-the-counter (OTC).
Currency forwards lock in an exchange rate for a certain period to hedge foreign currency exposure.
Currency forwards are individually negotiated, customizable and trade over-the-counter (OTC), meaning contracts can be made with any currency.
Currency forwards are OTC-traded, privately-negotiated deals used in forex markets to lock in an exchange rate for a currency pair. The contract’s pricing terms depend on the interest rate differential between currencies and the contract length. They are highly-customizable and are commonly used for hedging by both traders and companies with international business interests.
