What is a Forward Contract & how are they Priced?
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What is a Forward Contract
A Foreign exchange forward contract (forward) is an agreement that allows you to secure a rate today for a currency exchange that will take place at some date in the future.
As hedging with a forward provides greater visibility over the value of future dated for foreign currency receipts and payments in your local currency, it can allow a business to plan ahead with greater confidence.
Because the spot FX rate continues to move after you’ve fixed your forward rate, your forward contract can have a positive or negative value at different points in time. Consequently, your FX provider may require you to pay an initial deposit when you book the forward and/or an additional deposit depending on the path that the spot rate takes after the forward contract is agreed. If your forward contract is in the money and you do not require the monies, then selling a forward contract is an option.
How is a Forward Contract Priced
The rate on the forward is today’s spot FX rate adjusted by the forward points. Forward points are simply a mathematical adjustment based on the differences in interest rates between the two currencies and the length of time until the settlement date. When interest rates for the two currencies are similar, the forward rate will be close to the spot rate at the time you book the forward.
Strictly speaking, a forward is a contract where the settlement (exchange of currencies) takes place more than 2 business days into the future. In practice, many FX providers only consider an FX transaction a forward if the settlement date is more than 5 business days away.
Chart 1 illustrates how the gap between both US and UK interest rates and between US and Euro interest rates have halved since the start of 2019. As a result, 12 month forward points for GBPUSD have narrowed from +2.25c to +0.35c and for EURUSD, forward points have narrowed from +3.6c to +1.25c.
Unfortunately, lower forward points has made forward hedging less attractive for dollar buyers who would previously have been able to secure a 12 month forward rate 2.25c above the spot rate when selling sterling and 3.6c above spot when selling euros.
The corollary is that pricing is now a lot more attractive for exporters who sell in dollars as they can now lock in a FX forward rate that is very close to the current spot price, removing this disincentive to hedge especially for longer dates. The change in forward points alone has provided a UK based exporter with US$1m in revenue with a saving of £3,000 on a 3 month GBPUSD forward and a £12,600 benefit on a 12 month forward as compared to rates available a year ago. For a euro based exporter, the savings are even larger at €3,800 and €15,200 respectively.
Why use a Forward Contract?
The purpose of an FX forward is to secure an exchange rate today for a currency transaction that will take place at some point in the future. This might be done, for instance, if a company is trading internationally and has receipts or payments that are priced in another currency.
How does a Forward Contract Work
This is probably best explained by way of an example:
A German business enters into an agreement to sell its goods to a client in the USA and expects to receive $1m in 3 months’ time. The spot FX rate is 1.1500 at the moment and the German Finance Director is concerned that the dollar may weaken by the time the dollars are received in 3 months.
Instead of waiting and taking a chance on where the spot rate will be trading in 3 months time, the Finance Director sells US$1m forward at a rate of 1.1550 with the settlement to take place in 3 months time. The forward rate is higher than the prevailing spot rate because euro interest rates are lower than US interest rates. This means the outright forward contract is more favourable than the spot contract.
In 3 months time, the German firm receives its US$1m into its own designated US$ account at CommSense FX. CommSense FX converts the US dollars to euros at the agreed forward rate of 1.1550 and on the same day, CommSense FX puts the €865,800 into the German firm’s euro account with CommSense FX, ready to be used by the German firm.
Advantages of a Forward Contract
· An FX forward provides certainty and visibility in your local currency over the value of future-dated foreign currency receipts and payments
· An FX forward can be tailored to exactly match the timing and amount of your currency exposure
Disadvantage of a Forward Contract
· An FX forward is a contractual commitment
· As the spot rate continues to move after you have booked your forward rate, your forward may have a positive or negative value until the forward is settled. If the forward has a negative value, you may have to provide an initial deposit to your FX provider to enter a forward and may be asked to provide additional deposits at short notice also
· You are making a commitment to settle the forward- how likely is it that the underlying transaction that created the FX requirement is likely to occur?
· If there are recurring cash flows, what is the right amount of currency risk to hedge and how far into the future should you do this? This decision will depend on factors like your tolerance for risk
· If the forwards are out of the money, you may be asked to provide a deposit at short notice. Will you have access to sufficient liquidity to collateralise the forward, if required?
Type of Forward Contract
Tactically, the smaller forward point adjustments mean that Window Forwards may now look a better alternative to Fixed Forwards. Open window forwards provide a firm with the flexibility to use a FX forward contract within a chosen period instead of to a specified fixed date and is a better, more accommodating solution when there is uncertainty around the date of the payment or receipt of currency.
Previously, the greater flexibility offered by an open window forward had come at a cost as the firm would have been charged the forward points to the end of the window (if a cost) or received the forward points to the start of the window (if a benefit) but as the forward price adjustment has moved closer to zero, so has the cost of flexibility; a real benefit in these uncertain times.