FX Forward

Lock in a future exchange rate

The simplest way to remove currency uncertainty from a future cash flow. Two parties agree today to exchange one currency for another on a fixed date at a fixed rate, and both are obliged to go through with it whatever spot does in the meantime. The rate is not a forecast: it is today’s spot adjusted by the interest rate gap between the two currencies, because anything else would let someone borrow in one currency, lend in the other and pocket the difference risk-free.

Open in the app · FX · foundational

The lesson

1. What it is

An FX forward is a customised OTC agreement to exchange two currencies at a fixed rate on a specified future date. Both currencies are actually delivered on that date, and neither side can walk away — that firm obligation is what separates a forward from an option.

Spot in most currency pairs settles two business days after the trade date. Anything dated beyond that spot date is a forward; USD/CAD is the main exception, settling one business day after trade.

2. How the rate is set

The forward rate is the spot rate adjusted by forward points, which come from the interest rate differential between the two currencies. The currency with the higher interest rate trades at a forward discount — otherwise borrowing in one and lending in the other would be a free profit. Quote convention decides the direction of the adjustment: in EUR/USD the euro is the base currency and the dollar the quote currency, so the rate reads as dollars per euro, and when dollar rates sit above euro rates the forward rate is above spot.

Forward points are quoted in pips — the fourth decimal place in most pairs, but the second in yen pairs, where USD/JPY moves in units of 0.01.

3. Why it’s used

Companies use forwards to lock in an exchange rate for future receivables or payables, removing uncertainty from currency moves. An importer with a known foreign-currency bill buys that currency forward; an exporter expecting foreign-currency revenue sells it forward. In both cases the domestic-currency value of the cash flow is fixed on the day the hedge is done, not on the day the money arrives.

4. Key terms

Spot rate, forward points, value date and notional define the trade. The value date is the day the two currencies actually change hands. An outright forward is a single exchange on one date, while a window forward lets the company settle at any point across a range of dates.

A window forward is priced conservatively, because the dealer has to assume the client will pick whichever date in the window suits the client rather than the dealer.

5. Risks to watch

A forward is a firm obligation, so if the underlying exposure disappears — an expected sale falls through — the company is left holding an unwanted currency position that can only be removed by trading out of it at the market rate, crystallising a gain or a loss. Locking the rate also gives up any benefit if spot moves favourably, and the contract carries counterparty risk until settlement.

A US importer fixes a euro payable

A US company owes €10,000,000 in six months. In EUR/USD the euro is the base currency, so the rate is dollars per euro.
Spot is 1.0800, six-month dollar rates are 4% and six-month euro rates 2%.
The forward rate is 1.0800 × 1.0200 ÷ 1.0100 = 1.0907, so the forward points are +107.
Buying €10,000,000 forward at 1.0907 fixes the cost at $10,907,000.
If spot is 1.1500 on the value date, buying at market would have cost $11,500,000 — the forward saved $593,000.
If spot is 1.0500 instead, the market cost would have been $10,500,000 and the forward is $407,000 worse.

The dollar pays more interest, so it is worth fewer euros forward and EUR/USD rises with tenor. The 107 points are that interest gap, not a view on the euro — and because a forward binds both ways, the company gives up the good outcome along with the bad one.

Key terms

Spot rate — The rate for an exchange settling on the standard spot date, normally two business days after the trade.
Forward points — The adjustment added to or subtracted from spot to give the forward rate, driven by the interest rate differential.
Value date — The date on which the two currencies are actually delivered to each other.
Base currency — The first currency in a pair — the one whose price is being quoted, so EUR/USD is dollars per euro.
Outright forward — A single exchange of two currencies on one future date, with no offsetting near leg.
Window forward — A forward the client may settle on any date within an agreed range rather than one fixed date.

Every key term, A to Z

In practice

A UK importer paying dollar invoices ninety days after shipment uses forwards so the margin priced into the sale survives to the accounts, and an exporter selling into Europe does the mirror trade on its receivables. Fund managers run the same hedge at portfolio level, selling the currency of overseas holdings forward against the fund’s base currency and rolling the hedge as each contract matures.