The forward contract is a derivative transaction that is negotiated with the goal of reducing or eliminating exposure to risk. There are two types of forwarding contracts that are used in trading: currency forwards and interest rate swaps. A forex forward agreement is an agreement between two parties, usually made over the phone, to buy or sell an amount of foreign currency at a predetermined price and date. The forward contract is similar to a future but differs in that no actual currency changes hands until the settlement date of the forward. Unlike an FX spot trade, which generates immediate execution and payment for any transaction, both parties must initially agree on the specifics of their forward forex agreement. This includes the purchase or sale amount, the exchange rate, and the settlement date.
The most typical use of a forward contract is for hedging purposes, in which a holder of foreign currency may sell their currency to another party at an agreed-upon price for future delivery; if they wish to convert it back before that time their options will be limited by the market exchange rate.
A buyer and a seller of the same foreign currency usually have opposite interests. Thus, to secure a deal both parties need to meet each other's demands for a forward contract using one of the methods mentioned below.
Spot Transaction vs forwarding Contract: Understanding Forex Risk & Reward
One is always motivated by the desire to buy the currency with lower value and simultaneously sell the currency with higher value.
However, one party may have a greater urgency than the other party to complete the transaction. One way to address this is by entering into a forward agreement for two reasons:
1) The forward price agreed upon will be based on expected future spot prices, which allows a party to hedge against a move in either direction. The other party is motivated by the chance of taking advantage by buying low and selling high.
2) One party can demand a premium from the other for engaging in this forward contract because only one side desires to do the deal at that time; for example, if the spot price of EUR/USD is 1.4000, the forward price could be agreed to be 1.4020. The party that needs the currency now will buy at this higher price, and then turn around and sell it on the market for a guaranteed profit.