What it means
Imagine a company that must pay a foreign supplier in three months. It can wait and buy the foreign currency at the spot rate on the day, or it can agree a forward contract today that fixes the rate for that future date.
The forward margin is the gap between those two rates at the moment the forward is agreed. The margin is not a forecast of where the spot rate will end up.
It is driven mainly by the difference in interest rates between the two currencies, because the market prices out any risk-free profit from borrowing in one currency and lending in the other. A currency with a higher interest rate usually trades at a forward discount.
Traders also use the term to describe the amount a bank adds to or subtracts from the spot rate when quoting a forward price to a customer. In that sense it includes the interest-rate gap and, in some cases, the bank's own charge for taking on the deal.
It is worth asking your bank to separate the two so that you can see what you are really paying. For a treasurer, the margin is part of the cost of hedging.
A company that sells foreign currency forward at a discount will receive fewer dollars than the spot rate suggests, but in return it has certainty about the amount it will receive. That certainty is often worth the cost when budgets and prices have already been set.
The margin shrinks as the contract gets shorter, and it is zero on the day the forward matures because the forward rate converges with the spot rate. This is why a single quoted number must always be tied to a specific tenor, such as one, three or six months.
In practice
Real-world examples.
Example
A US furniture importer must pay EUR 800,000 to a supplier in 90 days. The treasurer asks for a forward quote and sees a forward margin of 35 points over spot. She decides the extra cost of about $2,800 is acceptable to lock in her budgeted margin.
Example
A software exporter expects to receive GBP 2,000,000 from a customer in six months and sells the pounds forward. The forward margin is a discount, so the company will receive slightly fewer dollars than at today's spot rate. The finance team records the difference as the cost of hedging.
Example
A bank's corporate desk quotes a mining company a one-year forward on Australian dollars. It adds a small extra margin to the pure interest-rate adjustment to cover its credit and handling costs. The mining company compares quotes from two banks before choosing.
Formula
Calculation
Forward margin = Forward rate - Spot rate
Suppose the spot rate for EUR/USD is 1.1000 and the 3-month forward rate is 1.1040. The forward margin is 1.1040 - 1.1000 = 0.0040, or 40 points, which is a premium because the forward rate is higher. Expressed as a percentage of spot, it is 0.0040 / 1.1000 = 0.36%.
If a company agrees to buy EUR 500,000 forward, it pays 500,000 x 1.1040 = $552,000 in three months. At the spot rate it would have paid 500,000 x 1.1000 = $550,000, so the margin costs it $2,000 in exchange for certainty.Case study
Seen in the real world.
Coastal Pines Trading is a fictional importer of ceramic tiles that pays its Italian supplier EUR 1,000,000 every quarter. For a long time it paid at the spot rate on the due date, and its profit margin swung with the exchange rate.
The new finance manager started buying euros forward three months ahead. With spot at 1.1000 and a three-month forward at 1.1050, the forward margin was 50 points, so each quarterly payment cost $1,105,000 instead of $1,100,000.
In this illustrative case the extra $5,000 per quarter was small compared with the swings of up to $60,000 the company used to experience. The managers accepted the margin as an insurance premium that made profit forecasts reliable, and the board approved a standing hedging policy.
Watch out
Common mistakes.
- Treating the forward margin as a prediction of where the exchange rate will be, when it mainly reflects the interest-rate difference between the two currencies.
- Comparing a forward rate with today's spot rate on the maturity date instead of the spot rate on the day the contract was agreed.
- Forgetting that the bank's quoted margin may include its own charge on top of the pure interest-rate adjustment.
Questions
People also ask.
Is forward margin the same as forward points?
They are closely related, since forward points are the margin expressed in the market's quoting unit, normally hundredths of a cent for most currency pairs.
Does a forward premium mean the currency is expected to strengthen?
Not necessarily, because the premium reflects interest rate differences rather than a market forecast of future spot prices.
Can the forward margin be negative?
Yes, when the forward rate is below spot the margin is a discount, which is common for the currency with the higher interest rate.
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