Forward contracts explained

What a forward is

A forward contract is an agreement to exchange a fixed amount of one currency for another, at a rate agreed today, on a specified date in the future. Nothing changes hands at the start, apart from any deposit the provider requires. On the settlement date, both sides deliver.

Its purpose is certainty. If you know you will need to pay or receive a foreign currency amount on a known date, a forward tells you today exactly what it will cost or be worth in your own currency.

How the price is set

The forward rate is not a guess about where the market will be. It is calculated from today's spot rate and the interest rates of the two currencies over the period of the contract.

The logic is simple. Instead of using a forward, you could convert your money today and hold the foreign currency on deposit until you need it. The forward rate has to leave you no better or worse off than doing that. So the currency with the higher interest rate trades at a discount in the forward market, and the one with the lower rate at a premium.

In this example the forward rate is below spot because sterling interest rates are higher. That does not mean anyone expects sterling to fall. It simply reflects the interest rate difference.

What you are committing to

Suppose a UK business must pay a US supplier $500,000 in twelve months and fixes a forward at 1.2639. The sterling cost is now fixed at £395,601, whatever happens to the exchange rate.

If sterling weakens, the forward protects the business. If sterling strengthens, the business still pays the agreed rate and gives up the better outcome. That opportunity cost is the price of certainty. A forward should be judged on whether it delivered the certainty it was bought for, not on whether it beat the market.

Margin and credit

Because a forward is a commitment to deal in the future, the provider takes a credit risk on you. Most providers either set a credit line or ask for an initial deposit, often a percentage of the contract value.

If the market moves against your position before settlement, you may be asked for further funds, known as a margin call. If you cannot provide them, the provider may close the contract early and you would bear any loss. Understand these terms before you sign, and keep enough liquidity to meet them.

When plans change

The biggest risk with a forward is a mismatch between the hedge and the underlying need.

• If a payment is delayed, the forward can usually be extended to the new date. The extension is priced at current market rates, so it can create a cost or a benefit.
• If a payment is cancelled, the forward must still be settled or closed out at the current market rate, which can create a gain or a loss that no longer has an offsetting exposure.
• If the amount changes, part of the contract may be surplus to requirements.

This is why hedging policies often cover a proportion of forecast flows, for example 50–75%, rather than the full amount, and hedge more as the amount and timing become certain.

Variations on the theme

• Flexible or window forwards fix a rate that can be drawn down at any time within a period, which suits payments whose exact dates are unknown.
• Non-deliverable forwards are used for currencies with capital controls. They settle the difference in a convertible currency, usually US dollars, rather than exchanging the restricted currency.
• Shariah-compliant forwards use a wa'd, a unilateral promise, rather than a bilateral contract to exchange at a future date.

Forwards are the right tool when the amount and date are known and certainty matters more than the chance of a better rate. When those conditions are not met, other tools, or a combination, may be more suitable.