Forward Exchange Contract

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Overview of Forward Exchange Contracts

Under a forward exchange contract, a company agrees to purchase a fixed amount of a foreign currency on a specific date, and at a pre-determined rate. This allows it to lock in the rate of exchange up front for settlement at a specified date in the future. The counterparty is typically a bank, which requires a deposit to secure the contract, with a final payment due in time to be cleared by the settlement date. If the company has a credit facility with the bank acting as its counterparty, then the bank can allocate a portion of that line to any outstanding forward exchange contracts, and release the allocation once the contracts have been settled. The forward exchange contract is considered to be an over-the-counter transaction, because there is no centralized trading location, and customized transactions are created directly between parties.

The price of a currency on the maturity date (its forward price) is comprised of the spot price, plus a transaction fee, plus or minus points that represent the interest rate differential between the two currencies. The combination of the spot rate and the forward points is known as the all-in forward rate. The interest rate differential is calculated in accordance with these two rules:

The currency of the country having a higher interest rate trades at a discount
The currency of the country having a lower interest rate trades at a premium.

For example, if the domestic interest rate is higher than that of the foreign currency, then forward points are deducted from the spot rate, which makes the foreign currency less expensive in the forward market. The result of this pricing is that the forward price should make the buyer indifferent to taking delivery immediately or at some future date. Thus, if the spot price of euros per dollar were 0.7194 and there was a discount of 40 points for forwards having a one-year maturity, then the all-in forward rate would be 0.7154.
The calculation of the discount or premium points follows this formula:

			Days contract duration
Premium/discount =	Exchange rate x interest rate differential	x	-----------------------
			360

There are a few problems with forward exchange contracts. First, because they are special transactions between two parties, it can be difficult to sell them to a third party. Second, the transaction premium offered may not be competitive.

Third, the forward exchange contract relies upon the customer paying the company on or before the date when the forward FX contract matures. It is possible to mitigate this problem with the variability of customer payments by entering into a forward window contract. This contract has a range of settlement dates during which the company can settle the outstanding contract at the currency rate noted in the contract. This contract is slightly more expensive than a standard forward exchange contract, but makes it much easier to match incoming customer payments to the terms of the contract.

A related problem is when a company enters into a forward exchange contract to hedge an anticipated cash flow, but it never happens at all; perhaps because a sale was canceled. In this case, the treasurer can enter into an offsetting forward exchange contract to negate the initial contract.

Example of a Forward Exchange Contract

Toledo Toolmakers has a 100,000 euro receivable at a spot rate of 1.39079. Toledo can enter into a forward FX contract with a bank for 100,000 euros at a forward rate of 1.3900, so that Toledo receives a fixed amount of $139,000 on the maturity date of the receivable. When Toledo receives the 100,000 euro payment, it transfers the funds to the bank acting as counterparty on the forward FX contract, and receives $139,000 from the bank. Thus, Toledo has achieved its original receivable amount of $139,000, even if the spot rate has declined during the interval.