The forward exchange contract is a special kind of foreign currency transaction. It is an agreement among two parties to exchange designated currencies at a specific time in the future.
The said contracts always occur on a date after the date that the spot contract settles and used to protect the buyer from fluctuations in currency prices.
A Better Understanding
Forward contracts don’t trade on exchanges. Then, standard amounts of currency also don’t trade in these agreements. The only way to cancel them is through a mutual agreement of both parties involved. Both parties in the contract are mostly interested in hedging a foreign exchange position of getting a speculative position.
Furthermore, the contract’s exchange rate is fixed and specified for an exact date in the future. And this lets the parties involved better budget for future financial projects and precisely know how much the income is, or costs from the transaction will be at the given future date. The character of forward exchange contracts protects the two parties from unexpected or disadvantageous movements in the currencies’ future spot rates.
Most of the time, forward exchange rates for most currency pairs can be acquired for up to one year in the future.
Now, there are four pairs of currencies that they call the ‘major pairs.’ And these are:
- The U.S. Dollar paired with the Swiss Franc
- The U.S. Dollar paired with the British Pound
- The U.S. Dollar paired with the Japanese Yen
- The U.S. Dollar paired with Euros
In these four pairs, exchange rates for up to ten years are possible. Also, contract times as short as several days are available from a lot of providers. As contracts can be customized, most entities won’t see the whole benefit of a forward exchange contract except setting a minimum contract amount at $30,000.
With the use of four variables, they can calculate the forward exchange rate for a contract.
Here, S means the latest spot rate of the currency pair, r(d) for the domestic currency interest rate, r(f) for the foreign currency interest rate, and t for the time of contract in days.
With that, the formula will look like this:
Forward rate = S x [1 + r(d) x (t/360)] / [1 + r(f) x (t / 360)]
For instance, let’s say that the U.S. dollar and Canadian dollar spot rate is 1.3122. Then, the U.S. three-month rate is 0.75% and the Canadian three-month rate is 0.25%.
Thus, the calculation for the three-month USD/CAD forward exchange contract rate will be:
Three-month forward rate = 1.3122 x [1 + 0.75% * (90 / 360)] / [1 + 0.25% * (90 / 360)] = 1.3122 x (1.0019 / 1.0006) = 1.3138