Forward contracts are one of the most common derivatives used in foreign exchange markets. For forex traders, understanding how forward contracts work and how to utilize them strategically can provide major advantages. This comprehensive guide will explain everything you need to know about forward contracts for FX trading.

What is a Forward Contract?

Definition and Key Characteristics

A forward contract is a private agreement between two parties to buy or sell an asset, in this case currency, at a specified price on a future date. The key aspects of a forward contract are:

  • Over the Counter (OTC) – Forwards are not traded on an exchange, but directly between two parties.
  • Customized Terms – The counterparties set the quantity, maturity date, exchange rate, etc.
  • Future Settlement – Payment and delivery occur at a future date, not immediately.
  • Legally Binding – Both parties are obligated to fulfill the contract at maturity.

Differences from Futures

While similar in function, forward contracts have some key differences from futures contracts:

  • Forwards are OTC while futures trade on exchanges.
  • Forwards can be customized while futures standardize terms.
  • Forwards do not require margin payments like futures.
  • Futures are marked-to-market daily while forwards are settled at maturity.

Parties Involved

The main parties in a forward contract are:

  • Long position – The party agreeing to buy the underlying asset in the future.
  • Short position – The party agreeing to sell the underlying asset in the future.
  • Counterparties – The two entities entering into the contract agreement. Often one is a commercial entity and the other a bank.

Function and Purpose of Forwards

Mitigating Currency Risk

The primary function of forward contracts is to mitigate, or hedge, future currency exchange risk. By locking in an exchange rate, parties protect themselves from adverse price moves.

For example, a U.S. exporter expecting payment from a sale abroad wants to hedge EUR/USD risk. He can enter a forward contract to sell EUR and buy USD at a set rate when he receives the payment. This locks in the exchange rate, eliminating uncertainty.

Speculation

Forward contracts can also be used for speculative purposes. Traders may use forwards to bet on the future direction of a currency pair and profit if their forecast is correct.

Speculation provides liquidity to the market but also increases risk if leveraged excessively. Regulators typically limit the amount of speculative forward trading banks can engage in.

How Do Forward Contracts Work?

Mechanics

When a forward contract is created, the rate agreed upon is called the forward rate and is determined by the spot rate adjusted for interest rate differentials between the currencies.

For example, if the EUR/USD spot rate is 1.2000 and euro rates are lower than dollar rates, the forward rate will be below the spot rate. The gap between spot and forward rates depends on the size of the interest rate differential.

At maturity, the holder of the long position will pay the forward rate to obtain the currency. The short position will receive this amount. Settlement occurs with a net payment in one direction.

Payoff at Maturity

The value of a forward contract is zero at inception since it is just an agreement. However, as spot rates change, a profit or loss builds up – this is called the marked-to-market value.

At maturity, the marked-to-market value becomes the realized profit/loss. The long position profits if the spot price exceeds the forward rate, while the short profits if the spot is below the forward rate.

Examples

Say a U.S. importer enters a 3-month forward contract to buy 100,000 EUR at a rate of 1.1975, when the EUR/USD spot rate is 1.2000. The market moves in his favor and the EUR/USD spot is 1.2150 on maturity.

  • Forward rate: 1.1975
  • Maturity spot rate: 1.2150

By locking in 1.1975 via the forward contract, the importer buys the EUR at a 0.0175 discount compared to the spot rate. This generates a profit of $1,750 (100,000 x 0.0175).

Conversely, if the EUR/USD spot falls to 1.1800, the importer would have been better off not using the forward contract. He would buy at 1.1975 rather than getting 1.1800 spot, losing $1,750.

Why Use Forwards for Currency Hedging?

Advantages Over Options

Forward contracts have some advantages that make them a very common hedging tool:

  • Cost – Forwards do not require an upfront premium payment like options contracts. The forward rate contains a small interest rate adjustment but there are no other upfront fees.
  • Simplicity – Entering into a forward contract is straightforward with standardized documentation and settlement procedures required.
  • Customization – Forwards allow tailoring the size, maturity, and settlement dates to individual needs.
  • Certainty – The currency rate is locked in definitively for the holder of a forward position. Options provide uncertainty until expiry.

Disadvantages vs Options

However, options offer some offsetting advantages that are absent with forwards:

  • Forward contracts can only hedge downside risk, options provide upside potential too.
  • Options allow benefiting from favorable currency movements, even if minimal.
  • Forwards have credit/counterparty risk. Options are settled cash on margin and cleared through exchanges.

Overall, forwards tend to be preferred by corporates for routine currency hedging needs. Options provide more complex payoff profiles for speculators or strategic hedging.

Common FX Forward Strategies

Forward Extra

A forward extra consists of a spot FX deal executed simultaneously with a forward contract longer than the spot value date. For example, a bank needing USD might buy USD spot and sell it forward one month. This provides short-term liquidity while locking in a rate longer-term.

Swap Points

In the interbank market, forward trades consist of paying or receiving swap points relative to the spot rate. If a trader thinks USD rates will fall, they can sell USD forward at a discount using negative swap points.

Forward Spread

This trading strategy aims to profit from widening or narrowing spreads between forward rates in different tenors. For example, a trader may bet the 1-month/3-month spread will narrow and place a combination of trades to capitalize.

Tom-Next Rollover

This short-term strategy involves trading the overnight forward swap rate known as tom-next. Traders can go long or short tom-next depending on the expected movement in overnight rates and spot levels.

Forward Volatility Trading

Analogous to trading FX options, it is possible to trade forward implied volatility. Traders use options pricing models to extract forward implied volatility and trade based on expectations for future realized volatility.

Forward Contracts for FX Hedging Examples

Exporter Hedging Receivables

An American exporter has sold machinery to a French company and is due to receive EUR 1 million in six months. Concerned about EUR downside, he takes out a 6-month forward contract to lock in a EUR/USD rate of 1.2000. In six months he delivers the EUR receivable and receives 1.2 million.

Multinational Firm Hedging FX Risk

A multinational firm based in Germany has subsidiaries worldwide with various currency exposures. The finance department enters a portfolio of forward contracts in all applicable currencies to hedge their budgeted expenses over the next year. This provides certainty for financial planning.

Importer Hedging Payables

A Chinese importer purchases commodities from Canada denominated in CAD. He is due to make a CAD 500,000 payment in 90 days. Worried the CAD could rise and cost him more RMB, the importer enters a forward contract today locking in the current CAD/RMB rate in 90 days’ time when he makes the payment.

Speculating on Interest Rate Differentials

A hedge fund believes the interest rate spread between the U.S. dollar and the Swiss franc will widen over the next 3 months. It enters into a 3-month forward contract to buy USD and sell CHF, profiting if USD rates rise faster and the dollar strengthens against the Swiss.

Key Risks of Trading Currency Forwards

Counterparty and Credit Risk

Since forwards are traded OTC, traders face risk that the counterparty defaults and does not honor the contract. Margining and collateralization help mitigate counterparty risk. But there is no central clearinghouse guarantee like with exchange-based derivatives.

Exchange Rate Risk

The inherent risk in currency forwards is adverse exchange rate movements. If rates move against a trader’s position, marked-to-market losses build until maturity. Imperfect hedging can also leave residual currency risk.

Interest Rate Risk

Changes in relative interest rates between currencies affect forward rates. Unexpected interest rate changes can impact the valuation of forward contracts.

Liquidity Risk

The OTC nature of forwards means they are less liquid than exchange-traded instruments. Exiting a position before maturity means finding a willing counterparty and likely accepting a discount to market value.

As legal contracts between counterparties, forwards rely on proper documentation and operational procedures for effective risk management. Legal disputes or operational failures can pose additional risks.

Forward Contracts: In Conclusion

Forward contracts offer forex traders and businesses a customized and straightforward instrument to hedge currency risk. By locking in an exchange rate, forward contracts mitigate downside risk while allowing participation in favorable rate moves.

While forwards have some inherent risks and disadvantages versus options, they are a staple derivative product for FX market participants. Understanding how to strategically utilize forwards provides a key tool for managing currency exposures and implementing both hedging and trading strategies.