Forward Forex Trade

Forward Deal

Forward deals are contracts for purchase of a given amount of foreign currency on a predetermined future date at a predetermined exchange rate. Delivery of the underlying currency is made on the deal’s maturity date.

Contrary to spot transactions, the date on which the forward deal is concluded differs from the date on which payment is made.

Forward exchange rate

Usually, the forward exchange rate differs from the spot rate of the underlying currency pair. If the forward rate is higher than the spot rate, we refer to forward premium and when the opposite is true – the term forward discount is used. The discrepancy in both rates reflects interest differentials for the two underlying currencies. If deposits, denominated in one of the two currencies, bear higher interest and that currency is sold forward, the seller is entitled to receive interest payments until the maturity date. In such a case the buyer of the forward is in a more unfavorable situation as he or she will not be able to make a deposit in the higher-interest-bearing currency until some time has elapsed. If the forward rate is lower than the spot rate, the buyer is compensated by the difference.

Forward exchange rate is calculated as follows:

spot rate +/– premium/discount = forward rate
Forward discounts or premiums are calculated as follows:

spot rate х interest differential х days to maturity

360 х 100 + (interest rate in the foreign country х days to maturity)

Usually, banks quote only bid/ask premiums or discounts as decimal numbers that are added to or deducted from the spot rate.

Forward duration and terms

Maximum forward duration in most currency pairs is 12 months, while in major currencies it is possible to conclude a forward deal with a maturity date exceeding 5 years. Most commonly used maturity dates are 1, 3 and 6 months but less frequent periods are also used.

A forward deal cannot be terminated. However, it is possible to conclude an opposite transaction – sale or purchase of the underlying currency, respectively – with the same maturity date. Net result from the two deals can be both a profit and a loss.

Considering the fact that execution of the forward deal is done on a future date, any brokerage company is entitled to require margin collateral. Its amount is calculated as a percentage of the total sum needed for the transaction and may subsequently be modified in respect to current market conditions. The collateral serves to cover any losses that the brokerage company may incur in case of possible incompliance with the contract’s terms and conditions by the other party.

Calculation of the forward rate – examples

A company exports goods to the US and expects to receive payment by its foreign partner in the amount of $100’000 in a six month’s time. In order to avoid currency risk, the company concludes a forward deal with a brokerage firm involving sale of the same amount of USD on a value date matching the date on which the money transfer is expected to take place.

Besides, the following facts should also be taken into consideration:

Spot rate for USD/BGN is 2.2092/100;
Annual interest rates on 6-month USD deposits are 1.75% – 2%;
Annual interest rates on 6-month BGN deposits are 4.50% – 5%;
Maturity date is 180 days.

In order to calculate the forward exchange rate, it is necessary to find the forward discount/premium (the difference between the spot and forward rates). Therefore, we are using the following formula:

spot rate х interest differential х days to maturity

360 х 100 + (interest rate in the foreign country х days to maturity)

0.0273 premium (BGN)

In this case the forward exchange rate equals the sum from the spot rate and the forward premium:

forward rate = 2.2092 + 0.0273 = 2.2365 BGN per $1.

In six months the company will make a transfer at the exchange rate of 2.2365 BGN per $1, i.e. the company will receive 223’650 BGN for the aforementioned $100’000. In such a case the company will save 0.0273 BGN for each $1. Besides, the company is interested in the current spot rate at the time the payment is made as it is already insured against currency risks through the forward deal.

Let us examine one more example:

A company owes the sum of $100’000 for imported goods from abroad to its foreign partner. In order to avoid currency risks, the company decides to conclude a forward deal with its servicing bank which allows it to buy the same amount of USD on a value date matching the date on which payment is expected to be made.

We take into consideration the same facts as before.

Spot rate for USD/BGN is 2.2092/100;
Annual interest rates on 6-month USD deposits are 1.75% – 2%;
Annual interest rates on 6-month BGN deposits are 4.50% – 5%;
Maturity date is 90 days.

In such a case the forward discount/premium is calculated as follows:

0.0179 premium (BGN)

In this case the forward exchange rate equals the sum from the spot rate and the forward premium:

forward rate = 2.2100 + 0.0179 = 2.2279 BGN per $1.

On the value date, i.e. in three month’s time, the company will buy the predetermined amount of USD at the exchange rate of 2.2279 BGN per $1, thus receiving 222’790 BGN for the amount of $100’000. In such a scenario hedging expense for the company amounts to 0.0179 BGN per $1.

Conclusion

Exporters, who sell forward foreign currencies, profit from the forward premium. This profit represents the return that is a result from the interest differential in both currencies and is commensurable with the time interval used for hedging.

Importers, who buy forward foreign currencies, lose the forward premium which represents the costs they incur to hedge against currency risks. The premium depends on the interest differential in both currencies and is commensurable with the time interval used for hedging. However, importers protect themselves against adverse exchange rate movements.