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FX Forward

What is an FX Forward?

An FX Forward is a contractual agreement between two counterparties, the client and the bank, or other non-bank provider, to exchange physical amounts in different currencies at a single set date in the future and at a set rate. A forward transaction differs from a spot transaction in the length of time between the trade date (the day the transaction is confirmed between the counterparties) and the day of settlement (when the currency is actually exchanged); the settlement, or maturity, date is also known as the value date. Settlement for most spot trades is T+2 (two business days after the trade date), whereas for forward trades settlement is anything greater than this.

Objective

The purpose of an FX Forward is to lock in the current exchange rate between two currencies at a set date in the future. This might be done, for instance, if a company is contractually obliged to pay a set amount for the future delivery of goods in a foreign currency, and wishes to lock in the current forward rate.

How does it work?

The two counterparties will look at the forward rates derived from the spot market and any negotiation will be over the spread the bank will take outside these projected forward rates. The FX Forward rate between two currencies will be different from the spot rate. However, the forward rate is directly derived from the spot rate in the form of an arithmetic adjustment to the spot rate based on the interest rate differential between the two currencies. The provider will also take a spread that will increase for trades of non-market size, whether small or large, and for the credit utilisation and liquidity risk of trading into the future.

Advantages
  • Provides total certainty over the rate of exchange in the future
  • A forward is an OTC (Over The Counter) instrument and can therefore be tailored to the exact requirements of the client as far as quantum and tenor are concerned
Disadvantages
  • Inflexible compared to options as it does not allow the client to benefit from advantageous movements in prices.
  • Some sort of credit line is always required, whether ‘margined’ or ‘clean’ i.e. with or without the need for margin payments.
  • Should the market move against the client, in the absence of a clean credit line, margin requirements by a bank or broker could force a client to post large quantities of collateral, adversely impacting the client’s cash flow.

FX Forward example:

 

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