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Guide

FX forward

Summary

An FX forward is a contractual agreement between the client and the bank, or a non-bank provider, to exchange a pair of currencies at a set rate on a future date.

What is an FX forward?

An FX forward is a contractual agreement between the client and the bank, or a non-bank provider, to exchange a pair of currencies at a set rate on a future date. The pricing of the contract is determined by the exchange spot price, interest rate differentials between the two currencies and the length of the contract, which the buyer and the seller decide.

Objective

The purpose of an FX forward is to lock in an exchange rate between two currencies at a future date to minimise currency risk. This might be done, for instance, if a company is contractually obliged to pay a set amount for the future delivery of goods in a foreign currency and wishes to lock in the rate.

How does it work?

A U.S. business plans to sell €2 million of products to a European company and receive the revenue in 12 months. The U.S. business is concerned that the dollar may strengthen against the euro and reduce the value of its exports. It enters into a FX forward to sell €2 million in 12 months to lock in the rate at $1 = €0.90 and protect its income. If, a year later, the spot price of one dollar is €1.10, the company will benefit from the contract. If the dollar has dropped to €0.80, the company will lose out under the contract by receiving fewer dollars for the euros than it would have at the spot rate.

Advantages

  • Provides certainty to the buyer regarding the cost of a future purchase
  • A FX forward can be tailored to the exact requirements of the client

Disadvantages

  • Clients are bound to honour the contract and cannot benefit from advantageous movements in currency prices
  • Should the market move against the client, bank or broker, margin requirements may adversely impact the borrower’s cash flow
fx forward profit and loss diagram

An example of a GBP/EUR FX forward showing how profit and loss changes as GBP weakens or strengthens.


Disclaimers

Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.

Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.

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