What it means
Most companies with cross-border trade know roughly when foreign currency will come in or go out, but not what it will be worth. A forward booking removes that second uncertainty by fixing the exchange rate for a specific amount and a specific value date.
When the date arrives, both sides must settle at the agreed rate. The forward rate is not a forecast.
It is calculated from today's spot rate adjusted for the interest rate difference between the two currencies over the period, which is why a currency with higher interest rates usually trades at a forward discount. Anyone reading a forward rate as the bank's view of the future has misunderstood the arithmetic.
Businesses generally book forwards against identified exposures: a confirmed export order, a supplier contract, a dividend from a foreign subsidiary. Some use a window forward, which allows settlement on any day within a range, because the exact payment date is uncertain.
Others book a rolling percentage of forecast exposure, hedging more of the near months and less of the distant ones. There are practical obligations attached.
The bank will usually require a credit line or margin, because if the market moves sharply against you the contract has a real cost, and a forward cannot simply be walked away from. If the underlying cash flow disappears, the forward still has to be closed out, sometimes at a loss.
The purpose is stability rather than profit. A treasurer who books forwards is deliberately choosing a known result over a possibly better and possibly much worse one, which is the right call when margins are thin and budgets have already been set.
In practice
Real-world examples.
Example
A UK-based components maker wins a two-year supply contract priced in dollars. It books a series of monthly forwards covering the expected receipts so that the sterling margin it quoted to its own board is the margin it actually earns.
Example
A travel operator buys hotel allocations in euros each spring for a summer season sold in dollars. It forward books 80% of the expected euro cost as soon as brochure prices are printed, because those prices cannot be changed later.
Example
A manufacturer expects a Japanese yen dividend from its subsidiary in nine months but is unsure of the exact payment week. It books a window forward that can be settled on any business day in a chosen month, avoiding the cost of rolling a fixed-date contract.
Formula
Calculation
Forward rate = Spot rate x (1 + quote currency interest rate x time) / (1 + base currency interest rate x time), where time is the fraction of a year.
An exporter expects to receive EUR 2,000,000 in six months. The spot rate is EUR/USD 1.1000, the annual dollar interest rate is 5% and the annual euro interest rate is 3%, so time is 0.5.
Forward rate = 1.1000 x (1 + 0.05 x 0.5) / (1 + 0.03 x 0.5) = 1.1000 x 1.025 / 1.015 = 1.1108 when rounded to four decimal places.
Booking the forward locks proceeds of 2,000,000 x 1.1108 = $2,221,600, a figure the exporter can put straight into its budget.
Suppose the spot rate has fallen to 1.0700 by the settlement date. Converting at spot would have produced 2,000,000 x 1.0700 = $2,140,000, so the forward booking was worth 2,221,600 - 2,140,000 = $81,600. Had spot instead risen to 1.1500, the unhedged proceeds of $2,300,000 would have beaten the booking by $78,400, which is the price of certainty.Case study
Seen in the real world.
Calderfield Bakeries is a fictional company created purely to illustrate the point. It imports Danish butter and Belgian chocolate, and it sets its retail prices for a full twelve months every autumn when supermarket listings are agreed.
For years Calderfield paid each euro invoice at whatever spot rate applied, and its gross margin swung by several percentage points from year to year for reasons that had nothing to do with baking. A 4% adverse currency move in one year wiped out most of the profit on its premium range.
The new finance director introduced a simple policy: once the annual price list is signed, book forwards covering 75% of the forecast euro purchases for the following twelve months, leaving the balance open for volume surprises. In this illustrative case, Calderfield's margin variance narrowed sharply, and although one year's forward rate turned out worse than spot, the board considered predictable pricing well worth that cost.
Watch out
Common mistakes.
- Judging a forward booking after the event by comparing it with the spot rate that eventually arrived, rather than by whether it delivered the certainty it was bought for.
- Reading the forward rate as the bank's forecast, when it is just spot adjusted for the interest rate difference between the two currencies.
- Booking forwards for more currency than the business will actually need, which turns a hedge into a speculative position when the underlying order shrinks or is cancelled.
Questions
People also ask.
What happens if the underlying payment is delayed?
The forward can usually be extended by rolling it to a new date, but the roll is priced at current market levels and may involve a cash settlement.
Does a forward booking cost anything up front?
There is normally no premium, though the bank builds a margin into the rate and may require a credit line or a deposit.
How much exposure should be hedged?
Many treasury policies hedge a high proportion of committed near-term cash flows and a lower proportion of uncertain longer-dated forecasts, tapering as visibility falls.
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