What is a Currency Forward?
A currency forward is a customized, written contract between parties that sets a fixed foreign currency exchange rate for a transaction that will occur on a specified future date. The future date for which the currency exchange rate is fixed is usually the date on which the two parties plan to conclude a buy/sell transaction of goods.
- A currency forward is a customized, written contract between two parties that sets a fixed foreign currency exchange rate for a transaction, set for a specified future date.
- Currency forward contracts are used to hedge foreign currency exchange risk.
- They are most commonly made between importers and exporters headquartered in different countries.
Understanding Currency Forward Contracts
Currency forward contracts are primarily utilized to hedge against currency exchange rate risk. It protects the buyer or seller against unfavorable currency exchange rate occurrences that may arise between when a sale is contracted and when the sale is actually made. However, parties that enter into a currency forward contract forego the potential benefit of exchange rate changes that may occur in their favor between contracting and closing a transaction.
While currency forward contracts are a type of futures contract, they differ from standard futures contracts in that they are privately made between the two parties involved, customized to the parties’ demands for a specific transaction, and are not traded on any exchange. Since currency forwards are not exchange-traded instruments, they do not require any kind of margin deposit.
Because currency forward contracts are private agreements between the parties involved, they can be tailored to precisely fit the parties’ respective needs regarding a monetary amount, the agreed-upon exchange rate, and the time frame that the contract covers. The currency exchange rate specified in a currency forward contract is usually determined in relation to prevailing interest rates in the home countries of the two currencies involved in a transaction.
When Currency Forward Contracts are Used
Currency forward contracts are typically used in situations where currency exchange rates can affect the price of goods sold.
A common example is when an importer is buying goods from a foreign exporter, and the two countries involved have different currencies. They may also be used when an individual or company plans to purchase property in a foreign country or for making maintenance payments related to such property once it has been purchased.
Currency forward contracts may also be made between an individual and a financial institution for purposes such as paying for a future foreign vacation or funding education to be pursued in a foreign country.
Currency forward contracts are most frequently used in relation to a sale of goods between a buyer in one country and a seller in another country. The contract fixes the amount of money that will be paid by the buyer and received by the seller. Thus, both parties can proceed with a firm knowledge of the cost/price of the transaction.
When a transaction that may be affected by fluctuations in currency exchange rates is to take place at a future date, fixing the exchange rate enables both parties to budget and plan their other business actions without worrying that the future transaction will leave them in a different financial condition than they had expected.
For example, assume that Company A in the United States wants to contract for a future purchase of machine parts from Company B, which is located in France. Therefore, changes in the exchange rate between the US dollar and the euro may affect the actual price of the purchase – either up or down.
The exporter in France and the importer in the US agree upon an exchange rate of 1.30 US dollars for 1 euro that will govern the transaction that is to take place six months from the date the currency forward contract is made between them. At the time of the agreement, the current exchange rate is 1.28 US dollars per 1 euro.
If, in the interim and by the time of the actual transaction date, the market exchange rate is 1.33 US dollars per 1 euro, then the buyer will have benefited by locking in the rate of 1.3. On the other hand, if the prevailing currency exchange rate at that time is 1.22 US dollars for 1 euro, then the seller will benefit from the currency forward contract. However, both parties have benefited from locking down the purchase price so that the seller knows his cost in his own currency, and the buyer knows exactly how much they will receive in their currency.
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