A currency forward is an agreement between two parties to exchange a certain amount of currencies at a certain time at a predetermined rate. A forward contract is unlike a futures contract. Each party believes that the current exchange rate will move in the desired direction in this contract until the contract expires. This contract is also known as "outright forward currency transaction," "forward outright" or "FX forward." There are two types of FX forward agreements:
Closed forward: An agreement to buy or sell has to be settled at a specific date.
Open forward: This agreement has a specific expiry date, but all or part of the contract can be paid for within that period.
Currencies fluctuate just like other commodities in the market. These fluctuations are dependent on interest rates, inflation, demand, and supply, economic policies, among other factors. FX forwards help investors or financial institutions control the perils of fluctuations in currency prices. FX forwards set the exchange rate for a specific time period in the future. In the future, the buying and selling of the currencies take place according to the prices mentioned in the agreement.
Currency Forward and Expected Future Spot Price
The expected future spot price is the market’s speculation of what the spot price of a currency will be in the future. Does the currency forward price predict the expected spot price correctly? There are a number of hypotheses trying to explain the relationship between these.
In a currency forward market, hedgers usually hold a net short position. Since their priority is to lower risks as much as possible, they are willing to lose some money to achieve this. On the other hand, speculators (forex traders) are interested in seeing their investments grow. Hence, they will enter into a contract only if they believe they can make money. Thus, if speculators are holding a net long position, it means that the expected future spot price is greater than the forward price.
Calculating the Currency Forward Exchange Rate
If FV denotes the future value of a currency, then:
FV = P (1+r) â¿, where P = Principal, r = annual rate of interest, and n = number of years.
The following equation can calculate the currency forward exchange rate:
Forward Exchange Rate = Spot Price X (Future value of quote currency/Future value of base currency).