FX Forward Contract (FEC)

 

What is an FX forward contract?

A forward contract is an over-the-counter (OTC) agreement between two parties to exchange a set amount of currency at a predetermined exchange rate (forward rate) on a specified future date. 

Forward contracts are commonly used to hedge against adverse currency fluctuations and protect against exchange rate risk. These contracts offer flexibility in terms of notional amounts and settlement dates, although one-month and three-month tenors are the most common due to higher market liquidity and lower transaction costs.

 

How do FX forward contracts work?

An FX forward contract is a financial instrument used to manage currency risk by locking in an exchange rate for a future date. Here's how it works:

• Agreement: Both parties agree on the terms of the exchange, including the currencies involved, the amount, the forward rate, and the settlement date.
• Fixed Exchange Rate: The agreed-upon forward rate is locked in, providing certainty against future currency fluctuations.
• Settlement: On the settlement date, the exchange occurs as per the contract terms, regardless of the current spot rate.

 

FX forward contract example

A UK (GBP) business sold $500,000 of products to a US (USD) client, with payment due in 12 months. Expecting a stronger USD against GBP, they use an FX forward contract to lock in the current exchange rate and hedge currency risk.

FX forward contract:

Forward rate: The UK business secures a forward rate of 0.75 USD/GBP

Transaction: $500,000 * 0.75 = £375,000

Settlement: After 12 months, the FX forward contract is settled and the UK business receives £375,000, minus any transaction fees.

Outcome one of the FX forward contract: If the exchange rate increases by the time of settlement, the UK business benefits by having locked in a lower rate earlier, resulting in cost savings.

Outcome two of the FX forward contract: If the exchange rate decreases, the UK business pays more than the current market rate because it is committed to the previously agreed higher rate.

 

Advantages of FX forward contracts

Mitigate currency risk: By locking in an exchange rate for a future transaction, businesses can protect themselves from potential losses due to fluctuations in currency values.

Flexibility: FX forwards are fully flexible in terms of notional amounts and maturities.

Forecasting: By locking in an exchange rate, businesses can create more accurate financial forecasts and projections, ensuring better financial planning and stability.

 

Disadvantages of FX forward contracts

Counterparty risk: Due to being OTC derivates, there is a risk that one party will not fulfil their contracted obligation.

Opportunity cost: Securing a fixed exchange rate through an FX forward contract could lead to missed opportunities for better rates if the market moves in their favour.

 

Forward contract vs future contract

Forward and future contracts are both financial agreements used to lock in exchange rates for a future date, helping businesses to manage currency risk. While they share the same core purpose, they differ in how they are traded and structured.

Forward Contract (FX Forward):
A forward contract, also known as an FX forward, is an over-the-counter (OTC) agreement between two counterparties exchange a specified amount of one currency for another at a predetermined rate on a future date.

FX forwards are highly customisable and are commonly used by businesses to hedge currency exposure and protect against adverse exchange rate movements.

Futures Contract (Currency Futures):
A futures contract, or currency future, is a standardised agreement between two parties to buy or sell a set amount of currency at a predetermined price on a specific future date. Unlike forwards, currency futures are traded on regulated exchanges, providing greater liquidity, transparency, and ease of trading.