What is a forward exchange contract?
A forward exchange contract is a special type of transaction in foreign currency. Futures contracts are agreements between two parties to exchange two designated currencies at a specific time in the future. These contracts always take place on a date after the date of settlement of the cash contract and are used to protect the buyer against currency price fluctuations.
Understanding the forward exchange contract
Futures contracts are not traded on the stock exchange and standard currency amounts are not traded in these agreements. They can only be canceled by mutual agreement of the two parties concerned. The parties involved in the contract are generally interested in hedging a foreign exchange position or taking a speculative position. The exchange rate of the contract is fixed and specified for a specific date in the future and allows the parties involved to better budget future financial projects and to know precisely in advance what will be their income or transaction costs at the future date. specified. The nature of the forward exchange contracts protects both parties from unforeseen or unfavorable fluctuations in future spot currency rates.
Key points to remember
- A forward exchange contract is an agreement between two parties to exchange two designated currencies at a specific time in the future.
- Futures contracts are not traded on the stock exchange and standard currency amounts are not traded in these agreements.
- Foreign exchange forward contracts are a mutual hedge against risk because they protect both parties against unforeseen or unfavorable movements in future spot currency rates.
Typically, forward exchange rates for most currency pairs can be obtained up to 12 months in the future. There are four currency pairs called “main pairs”. These are the US dollar and the euro; the US dollar and the Japanese yen; the US dollar and the British pound; and the US dollar and the Swiss franc. For these four pairs, exchange rates for up to 10 years can be obtained. Contract durations as short as a few days are also available from many suppliers. Although a contract can be customized, most entities will not see all the benefits of a forward exchange contract unless they set a minimum contract amount of $ 30,000.
Example of forward exchange rate calculation
The forward exchange rate of a contract can be calculated using four variables:
S = the current spot rate of the currency pair
r (d) = the interest rate in national currency
r (f) = the interest rate in foreign currency
t = duration of the contract in days
The formula for the forward exchange rate would be:
Direct rate = S x (1 + r (d) x (t / 360)) / (1 + r (f) x (t / 360))
For example, suppose the spot rate for the US dollar and the Canadian dollar is 1.3122. The US three-month rate is 0.75% and the Canadian three-month rate is 0.25%. The three-month USD / CAD forward exchange rate would be calculated as follows:
Three-month forward rate = 1.3122 x (1 + 0.75% * (90/360)) / (1 + 0.25% * (90/360)) = 1.3122 x (1.0019 / 1,0006) = 1.3138