FX Forward

An FX forward (or forward contract) is a binding agreement to exchange two currencies at a rate agreed today, with settlement at a future date. Unlike a spot transaction (which settles in two days) or a currency option (which gives a right), a forward is an obligation. When the settlement date arrives, both parties must exchange the currencies at the locked-in rate, regardless of what the spot rate has become.

How a forward contract works

A company in the UK expecting payment of $1 million from a US client in 90 days enters a forward contract with their bank:

• Rate agreed: GBP/USD forward = 1.2750 for 90 days
• Amount: $1 million
• Settlement date: 90 days from now

90 days later, the company delivers $1 million to the bank and receives £784,314 (1,000,000 / 1.2750), regardless of the actual spot rate on that date. If the spot rate is 1.3000 (pound stronger), the company receives fewer pounds than if they had waited — but they had certainty. If the spot rate is 1.2000 (pound weaker), the company receives more pounds than spot — the forward protected them.

Pricing: spot plus interest-rate parity

The forward rate is not a prediction. It is calculated from the spot rate and interest-rate parity: the difference between the interest rates of the two currencies.

If pound sterling interest rates are 5% and US dollar rates are 2%, the forward pound is weaker (more dollars per pound). An arbitrageur can profit from any deviation by borrowing at the lower rate and lending at the higher rate.

The result: forward rates are deterministic, not predictive.

Customization and OTC markets

Unlike currency futures (which come in standardized sizes and expiry dates), a forward contract is negotiated. You can ask for $1,234,567 worth of coverage, settling in 47 days. The bank will quote you a rate (bid and ask), and if you accept, you have a deal.

This flexibility is invaluable for corporate hedging. A company can match the forward exactly to the timing and amount of their expected cash flow.

No mark-to-market before settlement

With a forward, you do not pay or receive anything until settlement. If you lock in a 1.2750 forward and the spot moves to 1.3000 (in your favor), you have an unrealized gain, but there is no cash flow until 90 days later. You cannot “cash out” early without negotiating an exit with your counterparty.

In contrast, a futures contract is marked to market daily, and you receive or pay variation margin every day.

Counterparty risk

A forward is only as good as the bank’s creditworthiness. If your bank fails before settlement, you may be unable to execute the forward — or you may be stuck in a contract if the bank is obligated to deliver currency at a rate far from the market.

This credit risk is negligible for large, solvent banks but can be significant for smaller banks or in emerging markets. Large institutional users mitigate counterparty risk by requiring collateral (CSA agreements) or by using clearing houses (though most OTC forwards do not use clearing).

Forward books and dealers

Banks operate forward desks that make prices to customers and to other banks. A bank’s portfolio of outstanding forwards is its “forward book.” Dealers manage this book by hedging with spot and swap transactions, ensuring they are not exposed to currency movements.

A dealer quoting a 6-month EUR/USD forward is immediately hedging the position with a spot purchase of euros and a 6-month euro funding (borrowing euros). The dealer’s profit is the small bid-ask spread between what they quote the customer and the cost of the hedge.

See also