Forward contracts are a type of derivative – a financial contract that gets its value from an underlying asset such as a company share or a loan or coffee beans. In the case of foreign exchange derivatives, the underlying asset is usually the exchange rate between two currencies.
When you enter into a forward contract – in foreign exchange, this is known as a “currency forward” – you agree to buy or sell a certain amount of currency at a predetermined exchange rate at some date in the future. So, in effect, you’re locking in the exchange rate for the duration of the currency forward.
Let’s say you agree to exchange £5,000 for Euro in 4 months’ time at an exchange rate of EUR/GBP 1.17 – the so-called “forward exchange rate.”
Entering such a contract would allow you to know today that, in 4 months’ time, you’d get €1 for every £1.17. This means that you know for sure you’ll get €5,850 for your £5,000, regardless of what happens to the EUR/GBP exchange rate on the open market between now and then.
The forward exchange rate is worked out using the spot price – the market exchange rate at the time the contract is agreed – and the “interest rate differential” over the term of the contract. The interest rate differential is the difference in interest rate between two currencies.
So, using our previous example, if the European Central Bank sets the interest rate at 5% while the Bank of England sets the interest at 3%, the interest rate differential between the Euro and the British Pound is 2%. The reason the interest differential influences the forward exchange rate is that interest rate changes influence currency exchange rates (and are used by governments’ central banks to do precisely this).
The main benefit of a currency forward is that it allows you to fix a desired exchange rate for the duration of the agreement. If you’re a business that trades internationally or pays suppliers in foreign currency, this is very useful, because:
- It helps you manage your exposure – the risk you could lose money due to exchange rate fluctuations
- Knowing what the exchange rate will be ahead of time gives you certainty and peace of mind. You can budget for expenses and forecast your income much more accurately
Some Facts
- Forward contracts work the same way as futures: both allow you to fix the price of an underlying asset at a future date. The main difference between them is that futures are traded on exchanges, so they have standard terms. By contrast, forwards are private agreements, so there’s room for you and the other party to tailor the terms to your exact requirements.
- Forward contracts have been commonplace in some shape or form since Ancient Greece, when merchants funded their voyages with contracts known as bottomry.
- Bottomry allowed people to bet on the success of a voyage. The merchant would borrow money against the value of their cargo. If the cargo reached its destination safely, they repaid the loan with interest. If the ship sank, the lender forfeited the loan.
- Bottomry gave rise to the first attempted fraud ever recorded. In 300BC, a merchant called Hegestratos had the brilliant idea of selling his cargo then sinking his ship and pocketing the bottomry loan.
- Unfortunately, it didn’t go according to plan. Hegestratos’ crew caught him red-handed while he was trying to sink the ship and he drowned trying to escape them.
Want to know more?
- This illustrated tutorial explains how currency forwards work in detail, including how the forward exchange rate is typically worked out.
- Forward contracts and, indeed, derivatives more generally are widely misunderstood. This paper busts 10 myths about financial derivatives and sets the record straight.
ALT21’s perspective:
“With uncertainty caused by Covid-19 and, now, Brexit, UK exporters are increasingly worried about currency volatility. Forwards can help you lock in a favourable exchange rate with important overseas partners, and gain certainty and peace of mind at minimal upfront cost.”
