What it means
A forward is agreed directly with a bank rather than bought on an exchange, which means the amount and the date can be tailored exactly to the underlying transaction. No money changes hands at the outset beyond any credit or collateral arrangements the bank requires.
The forward rate is not a forecast. It is the spot rate adjusted for the interest rate difference between the two currencies, because a bank hedging the contract borrows in one currency and deposits in the other, and that cost is what sets the price.
Businesses use forwards to fix the cost of imported goods, the value of export receipts, or the domestic amount of a foreign currency loan repayment. Fixing the number lets a company set prices and budgets with confidence rather than repricing every time the market moves.
The main practical risk is over-hedging. If a forecast sale falls through the forward still has to be settled, which turns a hedge into a speculative position, so most treasury policies hedge the full amount of contracted exposures and only a proportion of forecast ones.
The variants are worth knowing. A window forward allows settlement across a range of dates, a non-deliverable forward settles the difference in cash where the foreign currency cannot be delivered, and a currency option gives the right without the obligation in return for an upfront premium.
In practice
Real-world examples.
Example
A furniture importer agrees a forward to buy 400,000 euros in ninety days at $1.1200 so that its landed cost per container is fixed before the season's catalogue prices are printed. The margin it advertises is therefore the margin it earns.
Example
An exporter of medical devices sells forward the 1,500,000 Canadian dollars it expects from a signed contract, protecting the margin quoted three months earlier. Because the sale is contracted rather than forecast, the hedge carries no risk of being left stranded.
Example
A group treasurer hedges 70% of forecast foreign currency purchases with forwards and leaves the rest open. Forecasts are never exact, and an over-hedged position would create the very risk the policy exists to remove.
Formula
Calculation
Forward rate = Spot rate x (1 + (domestic interest rate - foreign interest rate) x time in years), a close approximation used for short maturities
A manufacturer must pay 2,000,000 pounds to a British supplier in six months. The spot rate is $1.2500 per pound, dollar interest rates are 5% and sterling rates are 3%, so the six-month forward rate is $1.2500 x (1 + (5% - 3%) x 0.5) = $1.2500 x 1.01 = $1.2625. Booking the forward fixes the cost at 2,000,000 x $1.2625 = $2,525,000, a number that goes straight into the budget. If sterling has risen to $1.3200 by settlement day, buying at spot would have cost 2,000,000 x $1.3200 = $2,640,000, so the forward saved $2,640,000 - $2,525,000 = $115,000. If sterling had instead fallen to $1.2000, buying at spot would have cost $2,400,000 and the forward would have cost $2,525,000 - $2,400,000 = $125,000 more, which is the price paid for certainty.Case study
Seen in the real world.
Pallas Cycle Works is an illustrative, fictional bicycle assembler used here to show how currency forwards change a business rather than just a spreadsheet. It imported frames priced in euros and repriced its own range only twice a year, which meant a bad exchange run could turn a planned 14% gross margin into 8% before anyone noticed.
The new finance director introduced a simple rule. Every confirmed purchase order was hedged in full with a forward on the day it was placed, and half of the rolling six-month forecast was hedged as well, so costs were no longer a moving target and the sales team could quote dealer prices for a full season.
The following year the euro moved sharply and Pallas made no windfall gain, which one director complained about at the time. The finance director's answer was that the company assembles bicycles rather than trading currencies, and that a predictable margin is worth more than an occasional lucky one.
Watch out
Common mistakes.
- Treating the forward rate as the market's prediction of the future spot rate, when it is simply the spot rate adjusted for interest rate differences.
- Hedging more than the underlying exposure, which converts a protective contract into an outright bet on the currency.
- Judging a hedge a failure because the market later moved favourably, rather than against the certainty it was bought to provide.
Questions
People also ask.
Do forwards cost anything upfront?
Usually no cash premium, though the bank uses part of the company's credit line and may ask for collateral if the position moves against it.
What happens if the underlying payment is cancelled?
The forward still has to be settled or closed out at market rates, which can produce a gain or a loss depending on where the rate has moved.
How is a forward different from a futures contract?
A forward is a private, tailored agreement with a bank, while a future is a standardised exchange-traded contract with daily margin payments.
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