Prepared by: Asrorova Durdona Baxtiyarova Feruza What Is a Currency Forward? A currency forward is a binding contract in the foreign exchange market that locks in the exchange rate for the purchase or sale of a currency on a future date. A currency forward is essentially a customizable hedging tool that does not involve an upfront margin payment. - What Is a Currency Forward? A currency forward is a binding contract in the foreign exchange market that locks in the exchange rate for the purchase or sale of a currency on a future date. A currency forward is essentially a customizable hedging tool that does not involve an upfront margin payment.
- The other major benefit of a currency forward is that its terms are not standardized and can be tailored to a particular amount and for any maturity or delivery period, unlike exchange-traded currency futures.
Currency forwards are OTC contracts traded in forex markets that lock in an exchange rate for a currency pair. - Currency forwards are OTC contracts traded in forex markets that lock in an exchange rate for a currency pair.
- They are generally used for hedging, and can have customized terms, such as a particular notional amount or delivery period.
- Unlike listed currency futures and options contracts, currency forwards do not require up-front payments when used by large corporations and banks.
- Determining a currency forward rate depends on interest rate differentials for the currency pair in question.
- Understanding Currency Forwards
- Unlike other hedging mechanisms such as currency futures and options contracts—which require an upfront payment for margin requirements and premium payments, respectively—currency forwards typically do not require an upfront payment when used by large corporations and banks.
However, a currency forward has little flexibility and represents a binding obligation, which means that the contract buyer or seller cannot walk away if the “locked-in” rate eventually proves to be adverse. Therefore, to compensate for the risk of non-delivery or non-settlement, financial institutions that deal in currency forwards may require a deposit from retail investors or smaller firms with whom they do not have a business relationship. - However, a currency forward has little flexibility and represents a binding obligation, which means that the contract buyer or seller cannot walk away if the “locked-in” rate eventually proves to be adverse. Therefore, to compensate for the risk of non-delivery or non-settlement, financial institutions that deal in currency forwards may require a deposit from retail investors or smaller firms with whom they do not have a business relationship.
- Currency forward settlement can either be on a cash or a delivery basis, provided that the option is mutually acceptable and has been specified beforehand in the contract. Currency forwards are over-the-counter (OTC) instruments, as they do not trade on a centralized exchange, and are also known as “outright forwards.”
Example of a Currency Forward - Example of a Currency Forward
- The mechanism for computing a currency forward rate is straightforward, and depends on interest rate differentials for the currency pair (assuming both currencies are freely traded on the forex market).
- For example, assume a current spot rate for the Canadian dollar of US$1 = C$1.0500, a one-year interest rate for Canadian dollars of 3 percent, and the one-year interest rate for US dollars of 1.5 percent.
- After one year, based on interest
The currency forward rate is merely based on interest rate differentials and does not incorporate investors’ expectations of where the actual exchange rate may be in the future. - The currency forward rate is merely based on interest rate differentials and does not incorporate investors’ expectations of where the actual exchange rate may be in the future.
Why Are Currency Forwards Used? - Why Are Currency Forwards Used?
- Currency forwards are used to lock in an exchange rate for a certain period of time. This is often used to hedge foreign currency exposure
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