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November 12, 2022

What are Forwards?

The Forward-Thinking Product That Can Save You a Lot of Heartache

Forward-thinking in the financial sector isn't what you probably think it is. Though there is some truth that it has to do with preparing and planning for your business. Forwards are a financial tool to help you offset market volatility.

What are forwards

What Is a Currency Forward?

A currency forward is a type of derivative FX product. It is a privately negotiated contract that locks in the exchange rate for the purchase or sale of a currency on a single specified future date. These contracts are entered into privately, referred to as an over-the-counter (OTC) transaction, and do not trade on a centralized exchange. They are also known as outright forwards.

Many hedgers use forward contracts to reduce an asset’s price volatility. A forward lets you know precisely what a given amount of foreign currency will be worth in the future, so you can feel secure that unexpected movement will not harm tomorrow’s profits. Terms are set at the execution of the contract, so a forward contract is not subject to price fluctuations. 

Let’s look at an example. Two parties agree to convert 1 million British pounds (GBP) into US dollars (USD) at a date six months in the future. They agree to do the transaction at today’s rate of $1.10 per pound. That means that the price for the transaction is fixed at that rate. Whether the pound goes up or down against the dollar, both parties know what the rate will be in the future.

A Forward is a privately negotiated contract that locks in the exchange rate for the purchase or sale of a currency on a single specified future date.

Forwards vs. Futures

Forwards share some of the elements of futures (check out our blog post on Futures). There's a long (buyer) and a short (seller) that agree to exchange an underlying asset. A forward is much more flexible because it is an OTC transaction. Unlike exchange-traded currency futures, its terms are not standardized, meaning parties can tailor the quantity, price, maturity, and delivery period.

Advantages of Forwards vs. Futures
  • Units: You can use any amount of currency (futures have standard sizes).
  • Maturity: You can specify an exact date of expiration (futures have predetermined expirations).
  • Cash or Carry: You can settle with cash or delivery (futures are physically deliverable).
  • No Upfront Costs: Upfront margin is typically not required, but you will need to have a business relationship with the dealer.

Disadvantages of Forwards vs. Futures
  • Little Oversight: Forward contracts are unregulated, while the Commodity Futures Trading Commission (CFTC) regulates futures.
  • Counterparty Risk: There is the possibility  that one of the parties will default.
  • Availability: Forwards are not readily available to retail investors or SMBs.
  • Remedy: Futures have a designated process for settling disputes while forwards do not.
What’s the Cost of a Forward?

FX forward pricing is calculated based on the spot rate and the interest rate differentials between the two currencies for the tenor of the forward. The calculation is based on what is known as an FX forward curve.

The FX forward curve does not include any market sentiments or forecasts of where future exchange rates will be. However, brokers often price in a spread to the forward or discount beneficial forward points if they expect the interest rate differential to change during the tenure.

Let’s Look Forward

Forwards are the foundational derivative. They can be as simple or as complex as you need them to be. What makes them attractive is that they’re customizable, but you must weigh that against the risk that they are not regulated (KYC, know your counterparty).

Are forwards the best solution for you? Maybe. They are one of the many tools available to help you manage your FX risk. Learn about your other options here.


Takeaways
  1. FX forwards are privately negotiated contracts (OTC) that lock in the exchange rate for the purchase or sale of a currency on a single specified future date. 
  2. Forwards are very flexible. You can tailor the quantity, price, maturity, and delivery period of the contracts.
  3. There is inherent risk involved with forwards as they are privately negotiated and not regulated by exchanges. 

Want to take the stress out of managing your forex risk? Let Pangea Prime help you mitigate your risk without the time, expense, and headache.

Pangea

AI Hedging for the Future. Empowering organizations to intelligently manage their Foreign Currency Exchange Risk with AI and Automation at scale in the cloud.

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